FIN307 Principles of Finance

Questions (4-1)

Define each of the following terms:

• PV; I; INT; FVN; PVAN; FVAN; PMT; M; INOM
• Opportunity cost rate
• Annuity; lump-sum payment; cash flow; uneven cash flow stream
• Ordinary (or deferred) annuity; annuity due
• Perpetuity; consol
• Outflow; inflow; time line; terminal value
• Compounding; discounting
• Annual, semiannual, quarterly, monthly, and daily compounding
• Effective annual rate (EAR or EFF%); nominal (quoted) interest rate; APR; periodic rate
• Amortization schedule; principal versus interest component of a payment; amortized loan

(4-2)

What is an opportunity cost rate? How is this rate used in discounted cash flow analysis, and where is it shown on a time line? Is the opportunity rate a single number that is used to evaluate all potential investments?

(4-3)

An annuity is defined as a series of payments of a fixed amount for a specific number of periods. Thus, \$100 a year for 10 years is an annuity, but \$100 in Year 1, \$200 in Year 2, and \$400 in Years 3 through 10 does not constitute an annuity. However, the entire series does contain an annuity. Is this statement true or false?

(4-4)

If a firm’s earnings per share grew from \$1 to \$2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain.

(4-5)

Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain.

(5-1)

Define each of the following terms:

• Bond; Treasury bond; corporate bond; municipal bond; foreign bond
• Par value; maturity date; coupon payment; coupon interest rate
• Floating-rate bond; zero coupon bond; original issue discount bond (OID)
• Call provision; redeemable bond; sinking fund
• Convertible bond; warrant; income bond; indexed bond (also called a purchasing power bond)
• Premium bond; discount bond
• Current yield (on a bond); yield to maturity (YTM); yield to call (YTC)
• Indentures; mortgage bond; debenture; subordinated debenture
• Development bond; municipal bond insurance; junk bond; investment-grade bond
• Real risk-free rate of interest, r*; nominal risk-free rate of interest, rRF
• Inflation premium (IP); default risk premium (DRP); liquidity; liquidity premium (LP)
• Interest rate risk; maturity risk premium (MRP); reinvestment rate risk
• Term structure of interest rates; yield curve
• “Normal” yield curve; inverted (“abnormal”) yield curve

(5-2)

“Short-term interest rates are more volatile than long-term interest rates, so short-term bond prices are more sensitive to interest rate changes than are long-term bond prices.” Is this statement true or false? Explain.

(5-3)

The rate of return on a bond held to its maturity date is called the bond’s yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond’s price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond’s price? Why or why not?

(5-4)

If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

(5-5)

A sinking fund can be set up in one of two ways. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders.

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