FIN307 Principles of Finance

By Support

FIN307 Principles of Finance

Questions (4-1)

Define each of the following terms:

  • 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


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?


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?


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.


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


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


“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.


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?


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.


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.