Question

1. Lily manages a bond portfolio and believes that market interest rates are going to increase over the next several months. Accordingly, she should:

I.             Reduce the average maturity of the portfolio by selling long-term bonds and buying short-term bonds.

II.            Lengthen the average maturity of the portfolio by buying long-term bonds and selling short-term bonds.

III.           Reduce the average coupon rate by selling high-coupon bonds and buying low-coupon bonds.

IV.          Increase the average coupon rate by buying high-coupon bonds and selling low-coupon bonds.

A. II only   

B. III only

C. I and III only

D. I and IV only

E. II and III only

2. Suppose a firm uses a constant WACC in determining the value of capital budgeting projects rather than using the security market line. The firm will tend to _________.

               

                I.             accept profitable, low risk projects

                II.            accept unprofitable, high risk projects

                III.           reject profitable, low risk projects

                IV.          reject unprofitable, high risk projects

               

                A.            II only

                B.            III only

                C.            I and IV only

                D.            II and III only

                E.            III and IV only

Answer 1

Question 1:

Let us analyse all the options one by one and find out the correct approach to deal with increasing market interest rates

• Option 1 - A bond with longer maturity life is likely to experience a higher risk than a bond with short term maturity when there is a rise in market rates.This is because once the market rates increase, the holders of the long term bond who wish to sell their bonds before the maturity date would suffer a loss as the price of the bonds would decrease due to increased market rate.The holder would wish to sell the bonds as he will be underpaid till the maturity if he/she continues to hold it as the existing coupon interest is less than the market rate . Hence it is advisable to sell the long term bonds and buy short terms to reduce risk
• Option 2 - As explained in the above option, buying long term bonds and selling short term bonds would further increase the risk. Hence this option is not advisable.
• Option 3 - A bond with lower coupon rate is likely to experience a higher risk than a bond with higher coupon rate when there is a rise in market rates..This is because once the market rates increase, the prices of the bonds will start to fall. The rate of decline in the value of bonds is more for lower coupon bonds as compared to higher coupon bonds. Hence this option is not advisable.
• Option 4 - As explained in the above option, buying higher coupon bonds and selling lower coupon bonds would further reduce the risk. Hence this option is preferred.

Hence Option C (Option 1 & 3 ) would be the right choice

Question 2:

Weighted Average Cost of Capital is one of those approaches used to calculate the cost of capital incurred by a company. This approach uses equity and debt as main sources of finance and and their respective weights or proportion in the total amount of capital.

The main problem with WACC approach is that it fails to consider the fact that risk differs for every unit of business. It assumes that the risk rate is same for every business. Due to this assumption, the company would sometimes tend to reject profitable, low risk projects and accept unprofitable, high risk projects.

Hence Option D (Option 2 & 3 ) would be the right choice