Chapter 1

Chapter 1
Chapter 1, Problem 1MC
Step 1 of 3
Corporate finance meaning is related with the finance area which have some funds with the
sources and the organizations capital structure is also linked with it. The manager also takes
some actions so they can higher the value of the firm.
Step 2 of 3
Corporate finance means which gives the abilities and skills of managers and mangers require
the following needs:
• They should identify and select the strategies of the firms and the single projects which get the
add value in their organization.
• They should forecast the requirements of money related to their organizations and also devise it
strategies for purchasing the funds.
Step 3 of 3
The main aim of the corporate finance is to increase the value of the shareholder which is
different from the finance that is managerial finance, it consist of two items capital budgeting
and the working capital. The firm have to manage both aspects to increase their value and to
maintain their goodwill.
Chapter 1, Problem 1P
Step 1 of 4
Treasury securities are the securities which have a debt obligation related to the U.S government.
To buy this security, then they can borrow the money from the government from a time.
Treasury securities are like bills, and bonds.
Here,
“ ” is the nominal rate
“ ” is the real rate
“ ” is the inflation premium

“ ” is the default risk premium
“ ” is the liquidity premium
“ ” is the market risk premium
Step 2 of 4
The risk-free rate is 3%, inflations rate is 2% in current year and 4% for next 2 years. The
maturity risk premium is zero.
Step 3 of 4
Calculate the yield on 2-year treasury securities as follows:
Therefore, the yield on 2-year treasury securities is .
Step 4 of 4
Calculate the yield on 3-year treasury securities as follows:
Therefore, the yield on 2-year treasury securities is .
Chapter 1, Problem 1Q
Step 1 of 3
a. Sole Proprietor
Sole proprietor means the individual person who takes all decisions of the work. One person
bears the all losses and all profits occur in the business. In this the person need less capital to
start the work.
Partnership
It means when two or more people start their work and take all the decisions related to their
business, they get registered under the partnership Act 1932. In this the capital is more as
compare to the sole proprietorship.
Corporation
Corporation means the company or any firm which take their decisions on the basis of the
market. Corporation means one big company or large company where shareholders invest their
money.
Step 2 of 3
b. Limited partnership, limited liability partnership and Professional corporations
It the partnership which contains the general partner and it also manage the business and partner
has an unlimited liability on their debts. In limited liability partnership where all or some
partners have some limited liabilities, in this all partners are liable for the debts. The Professional
corporations are known as the big companies or entities and they make some special provisions
and regulate their business as per fixed provisions.
c. Stockholder wealth maximization means which have some objective related to the decisions of
higher authorities. In this the risk and time is linked with the expected earnings (per share). In
this cash flow is also linked with the price maximization of the company.
d. Money market is that market where the financial instruments have more liquidity and also
gave short maturity time period. The lending and borrowing is of short term. Capital market
means long term securities get traded and it have long maturity period, primary market means
where new or fresh securities get sold for the very first time and in secondary market the where
the securities again get sold after the first issue.
e. Private markets means the, market which is run by the some private companies they buy and
sell their securities which are linked with the equity of a private, public markets there are some
contracts which get traded on the exchanges which are organized in nature and derivatives are of
two types futures and options, the value of it is based on the assets rate.
f. Investment banker is a single person who works for the financial regions and the main duty of
the banker is to raise the funds or capital for the companies and for government companies,
financial service corporation means which give many facilities, it is a company which offers the
services like brokerage, and related to banks services and financial intermediary means the
middle person who give facilities to the person and charge commission from both sides.
g. Mutual fund means the funds where the person can diversify their funds in different portfolio
and also diversify their risks by investing their money in different sectors. Money market funds
is one type of the mutual funds, in this the investors invest their money for the short term.
h. Physical location exchanges means which give facilities of communication to the buyers and
to sellers both can easily communicate with them and take information on their securities and
computer/ telephone network contains all the services which give the transactions related to
security and don’t get conducted with the physical exchange.
 Step 3 of 3
i. Open outcry auction is one way to match the purchasers and buyers, in this auction both have
direct communication , dealer market the person hold the security of a inventory and also offer
the securities for buying and selling, electronic communications network (ECN) it is automatic
machine which match various securities and it is linked with the all computers.
j. Production opportunities means the return which is provided in the nation from the investment
when the production is more the firm will get more capital and time preferences for consumption
get establish that how much consumption get defer and save at the various interests levels.
k. Real-risk free rate of interest means which have equal Supply and demand the securities have
inflation at the zero rates. It is also known as a pure interest rate. Nominal risk free rate of
interest means the risk which is having a rate of risk free and the premium get added in the
expected inflation.
l. Inflation premium means which get added with the real risk interest rate and it get
compensation from the loss also, default risk premium when the borrower is not able to pay the
amount of interest or principal amount of the loan and then it get added in the rate of risk free
and liquidity means the when the firms have goods liquidity by having good amount of cash or
liquid assets by selling the goods they can get cash and liquidity premium get added in the rate of
real risk-free interest rate.
m. Interest rate risk is the risk which gets change with the change in the levels of rate of interest
and it get spread in the two rates. Maturity risk means the rate of interest which gets change
when the money of the person is tie up in the bond till it gets on the date of maturity.
Reinvestment risks means which with the payment of the bond with its principal and interest
amount and it get again reinvested at fewer rates.
n. The structure of rat of interest is the relation with the rate of interest and with the yields of
bonds with having different maturity period. It is also known as yield curve and plays a crucial
role in the nation's economy.
o. The normal curve is that curve which shoes some instruments of debt which have short term
and also have fewer yields as compare to the long term and the abnormal yield curve means the
rate of interest where the debt instruments are of long-term.
p. Expectations theory is the theory the forward prices show the future expected rates. The whole
team shows the expectation s of the market for short rates.
q. Foreign trade deficit is the deficit where the measure is related to the international market. In
this the nations do import and exports of goods and services. The deficit shows that the outflow
of a domestic currency to the outer markets. It shows the negative balance on the trade.
Step 1 of 5
In a given economy, capital that is available with the net lenders is provided to the net borrowers
through a pricing system. For debt and mortgage securities, it is termed as interest rate and is
popularly referred as the cost of borrowing. The interest rate is determined by economic
conditions, opportunity costs for forgoing a consumption need, risk & uncertainty along with
prevalent general level of inflation rate.
Step 2 of 5
The nominal risk-free rate is composed of the sum of risk free rate, inflation premium, default
risk premium, the riskiness of the security & the security’s liquidity. The relationship is
expressed as follows: -
Here,
• r*: - Real Risk-free rate
• IP: - Inflation Premium
• DRP: - Default risk premium
• LP: - Liquidity premium
• MRP: - Maturity risk premium
• r: - Nominal bond yield
Step 3 of 5
A treasury bond has the required rate of return which is addition of risk free rate & inflation
premium, maturity risk premium. The treasury bond has the yield of 6% and a corporate bond is
at 8% yield. Additionally, liquidity premium is at 0.5% for corporate bonds.
Step 4 of 5
Additionally, treasury security has zero default risk premium. The treasury rate of 6% would be
sum of maturity risk premium, inflation premium & risk-free rate which would replace in
equation below. The reason being the maturity is same for both securities and both securities
would share same risk-free rate, maturity risk premium and inflation premium.
Step 5 of 5
Therefore, employing the available values in the formula, the results are as follows: -
The default risk premium of the corporate bond is .
Step 1 of 3
Following are the three principal forms of business organisations
1. Proprietorship
2. Partnership
3. Corporation
Proprietorship:
In proprietorship unincorporated business in owned by single individual. This individual is

responsible for managing the business and takes all the profit and bears all the losses suffered
from the business. To initiate a business operation a person just need city or state business
licenses.
Following are the three important advantages of proprietorship
1. It is easy and inexpensive to form

2. Only few government regulations need to be followed
3. Its income is not subject to corporate taxes and is taxed as proprietors personal income
Following are the three main disadvantages of proprietorship
1. It is difficult to raise capital needed for growth
2. Personal liability of the proprietor are unlimited for business’s debt, which in turn may result
in losses exceeding the money invested in the business
3. Life of proprietor ship is limited to the life of its founder
Step 2 of 3
Partnership:
Partnership come into existence when two or more person connect to starts a non corporate
business with the motive to earn profit. It may exist under different degree of formalities from
informal, oral to the written formal partnership agreement under the secretary of state in which
the partnership was formed. Partnership agreement determines the way profit and losses to be
distributed amongst the partners.
Advantages of partnership are as follows:
1. It is easy and inexpensive to form
2. Only few government regulations need to be followed
3. Its income is only taxed at partners personal level and is not subject to corporate taxes
Disadvantage of partnership
1. liabilities of the partners are unlimited: partners and not only liable to the extent of their
investment in business but their personal properties can also be used to meet business liabilities
if required.
2. Difficult to transfer ownership interest: no partner can transfer his interest(share) without the
consent of other partners
3. Difficult to raise capital for growth needs: due to the limited borrowing capacity of partners
and limited number of partners resources for the growth are limited to the personal funds of the
partners.
Step 3 of 3
Corporation:
It is a legal entity separate from its owner and manager created by state
The advantages of the corporation
1. Limited liability: losses are limited to the amount of fund invested
2. Indefinite life: corporation continues to exist even after its real owner and managers are dead
3. Ease of transfer of ownership interest: ownership interest is divided into shares of stock, which
can be transferred easily as compared to proprietorship and partnership
4. Easy access to capital markets: it is easy for corporation to raise funds needed for growth
Disadvantages of corporation:
1. Earnings are subject to double taxation: corporation earnings are taxes at corporate level and
when it is distributed as dividend to the common stockholder, they have to pay tax on dividend
income at their personal level .
2. For the registration corporation need to file state and federal reports to which is expensive,
time consuming and a complex process
Step 1 of 4
Step 2 of 4
Here,

Step 3 of 4
A treasury bond has the required rate of return which is addition of risk free rate & inflation
premium. The treasury bond has the yield of 6.2% and a corporate bond is at 8% yield.
Additionally, liquidity premium and default risk premium for the treasury bonds are always
equal to zero.
Step 4 of 4
The risk-free rate and inflation premium are at 3% respectively. Therefore, employing the
available values in the formula, the maturity risk premium are as follows: -
The maturity risk premium of the corporate bond is .
Step 1 of 3
Cash flows the full details of cash in or cash out, the cash flow get recorded in the firms and they
use this data while making the balance sheet. The profit and expense items are present in the cash
flows and then get into the balance sheet of the firms.
Step 2 of 3
There are three main determinants of organisation cash flows which are as follows:
• Sales revenue
Revenue means income the income which gets derived from the sales, the sales can of products
and services of the firm. And it get subtracted from the cost which is linked with the other sales
items like return in sales, the delivery of the product is not made.
• Operating expenses
These are expenses of the business which get incurs and get engaged into the activities and it is
not directly linked with the production of products or services. It is the expense of the company
related with the daily expenses, but production is not related with it.
Step 3 of 3
• The important investments in the operating capital like equipments and buildings. The firms
make a huge investment in the big projects like in constructing the big buildings and installing
new equipments and earn money from it.
Step 1 of 4
Step 2 of 4
Here,

Step 3 of 4
The real risk-free rate of the bond is at 3%. The inflation is 3% for first year, 4% next year &
3.5% for the remaining periods. The maturity risk premium is represented as the function of time
as 0.0005X(t-1).
Step 4 of 4
Here t or number of years to maturity is at 7 years. Liquidity risk premium & default risk
premium are zero for treasury securities. Employing the available values, the expected return is
computed as follows: -
The expected rate of return for the treasury security is at .
Step 1 of 1
Financial intermediaries are the business organization like bank or insurance companies which
buys securities with the fund it obtained by selling its own securities.
For example, common stock mutual fund buys securities from the funds obtained by selling its
share in mutual funds.
They pool fund from the small investors to make big investments and thus get advantage of bulk
trading (economies of scale, spreading of risk etc)
With the help of financial intermediations funds are allocated more effectively which in turn
results in increase in real output of the economy.
Step 1 of 5
Step 2 of 5
Here,
Step 3 of 5
The real risk-free rate of the bond is at 3%. The inflation is 8% for first year, 5% next year & 4%
for the remaining periods. Liquidity risk premium & default risk premium are zero for treasury
securities.
Step 4 of 5
The difference of maturity risk premium of the treasury security at 2-year maturity and 5- year
maturity has to computed where nominal yield remains at 10% for both time period Employing
the available values, the expected return is computed as follows: -
Step 5 of 5
The maturity risk premium between year 5 and year 2 is .
Step 1 of 2
Step 2 of 2
The short-term interest rates fluctuate more than the long-term interest rates. This is because
short-term interest rates provide more stimulus to the changes in the current market situation and
economic conditions. The long-term interest rates project the long-term economic conditions and
inflation rate of the nation. Short-term interests are monitored and changed from time to time by
the monetary policy established by the central bank of the nation.
Step 1 of 5
Step 2 of 5
Here,
Step 3 of 5
The real risk-free rate of the bond is at 2%. The inflation is 3% for first year, more than 3% next
year & for the remaining periods. Liquidity risk premium, maturity risk premium & default risk
premium are zero for treasury securities.
Step 4 of 5
The difference of yield of the treasury security at 1-year maturity and 3- year maturity was 2
percentage points. Employing the available values, the expected return is computed as follows: -
Step 5 of 5
The inflation risk premium between year 1 after is .
Step 1 of 3
Bonds meaning the instrument which have indebtedness and the holder of the bonds have this
indebtedness. It is a kind of debt security where the issuer also owes the debts of the holder and it
depends on the bonds terms which are obliged the holder to pay it with the interest.
Step 2 of 3
a. When the transfer is in the two markets which are costly than the rate of interest of both areas
are different. In Area Y, it is relatively related with the young population, which have lesser
savings and have more demand of loans. In Area O, it is relatively linked with the population
which is old, and it have higher savings and less demand of loans because the persons from the
old population buy their homes and these are less oriented consumed. Hence, the demand
equilibrium and the supply equilibrium will have more interest rate in the Y area.
Step 3 of 3
b. Yes, the branch all around the nation will have less cost of financial and it get transfers in the
different areas; such funds get flow from the O Area which has higher supply as related with the
Y Area which has higher demand. Such flow get increase rate if interest in the O Area and it
diminish the rate of interest in the Y Area till the rates get equal, the difference is known as the
transfer cost.
Step 1 of 8
Step 2 of 8
Here,
Step 3 of 8
The investor expects 7% inflation rate which may fall to 5% during the next year and 3% during
the next year to the rest of the tenure. The real rate of interest is 2%. The maturity risk premium
changes with 0.2 percentage to maximum of 1%.
(a).
The nominal interest rate for the bonds would be computed as follows: -
1st year bond: -

2nd year Bond: -
Step 4 of 8
3rd year bond: -
4th year Bond: -
Step 5 of 8
5th year bond: -
10th year Bond: -

20th year Bond: -
The following would display the finalized value of interest rates corresponding to time to
maturity which would be used to prepare the yield curve graph: -
Step 6 of 8
The yield curve would be prepared as follows: -

Step 7 of 8
(b).
E M is AAA rated firm with default rate as virtually as zero for bonds having short term
maturities. However, as time to maturity increases, default premium increases. The yield curve
of E M would be over the yield curve of treasury securities. The yield curve that would be
formed over such implications as displayed below: -
Step 8 of 8
(c).
The LILC is fairly risky firm due to its nature of business. It has high probability of default.
Therefore, it would have high default risk premium as compared to T-bonds and EM. The yield
curve would be plotted above the yield curve of EM and T-bonds
Step 1 of 3
It is the curve which get plotted on the rate of interest, which have some time points, the bonds
also have some credit quality and different time of maturity. These bonds also get rated by the
credit rating agencies and the investor buys the bonds by seeing the rating of the agencies.
Step 2 of 3
a. The effect on the yield curve is also lower and it have less rate of interest in the short-term end
market, the Fed also do deals with the mainly in the different segments of markets. Therefore the
persons also expect more inflation in the future, and it also raises the interest rates which are
long-term.
Step 3 of 3
b. When the policy is getting maintained, the money supply will get expand and it get results into
the higher inflation rates and more expectations of inflation. It results into that investors have
more premium of inflation on all the securities which are debt securities and the full yield curve
get rise and the entire rate will get more.
Chapter 1, Problem 8SP
Step 1 of 4
Inflation means when the rate of goods and services get increase from the general price and
consumers don’t have sufficient currency to buy the things. The currency's purchasing power get
decreases.
Step 2 of 4
a. The average of the expected inflation can be found by using this formula:
Given:
Year 1 Inflation rate (throughout the year)
Year 2 Inflation rate
Step 3 of 4
b. The prevailing interest rate on the 4 year T-bonds are as follows:
The formula is as follows:
Given,
Put these values and calculate the value of
Step 4 of 4
c. When the five-year T-bond rate of interest is , the rate of inflation will expect to have a
average of near about in coming give years. Hence, the implied five-year rate of
inflation is .

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Chapter 1

Chapter 1, Problem 1MC

“ ” is the nominal rate

“ ” is the real rate

“ ” is the inflation premium

“ ” is the liquidity premium

“ ” is the market risk premium

Calculate the yield on 2-year treasury securities as follows:

Therefore, the yield on 2-year treasury securities is .

Calculate the yield on 3-year treasury securities as follows:

Therefore, the yield on 2-year treasury securities is .

b. Limited partnership, limited liability partnership and Professional corporations

• r*: - Real Risk-free rate

• IP: - Inflation Premium

• DRP: - Default risk premium

• LP: - Liquidity premium

• MRP: - Maturity risk premium

• r: - Nominal bond yield

The default risk premium of the corporate bond is .

Following are the three principal forms of business organisations

In proprietorship unincorporated business in owned by single individual. This individual is

Following are the three important advantages of proprietorship

1. It is easy and inexpensive to form

Following are the three main disadvantages of proprietorship

1. It is difficult to raise capital needed for growth

3. Life of proprietor ship is limited to the life of its founder

Advantages of partnership are as follows:

1. It is easy and inexpensive to form

2. Only few government regulations need to be followed

The advantages of the corporation

1. Limited liability: losses are limited to the amount of fund invested

• r*: - Real Risk-free rate

• DRP: - Default risk premium

• LP: - Liquidity premium

• MRP: - Maturity risk premium

• r: - Nominal bond yield

The maturity risk premium of the corporate bond is .

• r*: - Real Risk-free rate

• IP: - Inflation Premium

• DRP: - Default risk premium

• LP: - Liquidity premium

• MRP: - Maturity risk premium

The expected rate of return for the treasury security is at .

• r*: - Real Risk-free rate

• IP: - Inflation Premium

• DRP: - Default risk premium

• LP: - Liquidity premium

• MRP: - Maturity risk premium

• r: - Nominal bond yield

The maturity risk premium between year 5 and year 2 is .

• r*: - Real Risk-free rate

• IP: - Inflation Premium

• DRP: - Default risk premium

• LP: - Liquidity premium

• MRP: - Maturity risk premium

• r: - Nominal bond yield

The inflation risk premium between year 1 after is .

• r*: - Real Risk-free rate

• IP: - Inflation Premium