Question

6. Why is it best to hold zero coupon bonds in a tax-deferred account like a 401K? A. Zero coupon bonds are tax exempt B. The IRS requires the holders of zero coupon bonds to pay taxes on the interest that accrues, even though they aren't receiving coupon payments C. The IRS allows investors to defer paying taxes on all zero coupon bonds D. The SEC mandates are zero coupon bonds be held in tax deferred accounts E. Both C and D 7. Why do corporate bonds pay a higher risk premium than municipal bonds? A. Neither corporations nor state and local governments can levy taxes B. State and local governments can print money, whereas corporations cannot C. Corporations can levy higher taxes than state and local governments D. State and local governments can levy taxes, whereas corporations cannot E. None of the above 8. According to the Dividend Discount Model, if the growth rate of a company's dividends increases, holding all else equal, then the value of the company's stock will A. Increase B. Decrease C. Stay the same D. Insufficient information E. None of the above 9. If a firm increases its plowback ratio, this will probably result in P/E ratio A. A higher B. A lower C. An unchanged D. Insufficient information (need to know ROE to better determine increase, decrease, or no change in P/E ratio) E. None of the above

Answer 1

6. It is best to hold zero coupon bonds in tax-deferred account like 401k because:

Answer 6. (B) The IRS requires the holders of ZCBs to pay taxes on the accrued interest, even though they aren't receiving coupon payments - That way the bondholder need not pay taxes till the coupon is actually received and effectively defer the tax.

7. Corporate bonds pay a higher risk premium than municipal bonds because:

Answer 7. (D) State and local governments can levy taxes, whereas corporations cannot - As a result, there are diverse revenue streams from various types of taxes like property taxes, sales taxes, income tax etc. that can be levied or modified which reduces the risk associated with municipal bonds compared to corporations and hence command lower risk premium compared to corporate bonds.

8. According to the Dividend Discount Model, if the growth rate of a company's dividend increases, holding all else equal, then the value of the company's stock will:

Answer 8. (A) Increase - This is because the value of the stock is basically the discounted value of all the future dividends. So, if all the other parameters (primarily the discount rate) hold equal, increasing dividends (due to increasing growth rate of dividends) with same discount rate will lead to an increased stock price.

9. If a firm increases its plowback ratio, this will probably result in:

Answer 9. (D) Insufficient information (need to know ROE to better determine increase, decrease, or no change in P/E Ratio) - This is because, an increased plowback ratio can lead to a higher P/E ratio only when the ROE is higher than investors' required return on equity. If the ROE is lower than the required return, then investors prefer higher dividend payout instead of plowback and hence in such case, an increased plowback can lead to a decrease in P/E ratio. If the ROE is equal to the required return, then a change in plowback ratio has no effect on the P/E ratio.