Part A: The Cost of Money

1. Assume that k* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t - 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07%(t - 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter. What is the difference in interest rates between 10- year AT&T bonds and 10-year Treasury bonds?

Part B: Debt and Bond Valuation

1. A $1,000 par value bond pays interest of $35 each quarter and will mature in 10 years. If your simple annual required rate of return is 12 percent with quarterly compounding, how much should you be willing to pay for this bond?

2. Discuss the relationship between bond value and interest rate changes. What effect do interest rate changes have on bond values on the secondary markets? As the maturity date on a bond approaches what happens to the effect, on bond value, of interest rates that differ from the coupon rate?