Chapter 5

Assume your current mortgage payment is $900 per month. If you begin to pay $1,000 per month (with the extra $100 per month going to principal), which of the following will be TRUE? A) The mortgage balance will decrease faster with $1,000 monthly payment compared to $900 monthly payments. B) The total amount paid (principal and interest) will increase with $1,000 monthly payment compared to $900 monthly payments. C) The total interest expense will increase with $1,000 monthly payment compared to $900 monthly payments. D) The total principal paid will decrease with $1,000 monthly payment compared to $900 monthly payments

a

The yield curve is typically ________. A) downward sloping B) upward sloping C) flat D) inverted

b

Which of the following is/are TRUE? I. The EAR can never exceed the APR. II. The APR can never exceed the EAR. III. The APR and EAR can never be equal. A) Only I is true. B) Only II is true. C) Only II & III are true. D) Only I & III are true.

b

Which of the following computes the growth in purchasing power? A) growth of money + growth of prices B) (1 + real rate) / (1 + nominal rate) C) (1 + inflation rate) / (1 + nominal rate) D) growth of money / growth of prices

d

Which of the following reasons for considering long-term loans inherently more risky than short-term loans is most accurate? A) There is a greater chance that inflation may fall in a longer time-frame. B) The penalties for closing out a long term loan early make them unattractive to many investors. C) Long-term loans typically have ongoing costs that accumulate over the life of the loan. D) The loan values are very sensitive to changes in market interest rates.

d

Which of the following statements is FALSE about interest rates? A) As interest rates may be quoted for different time intervals, it is often necessary to adjust the interest rate to a time period that matches that of cash flows. B) The effective annual rate indicates the amount of interest that will be earned at the end of one year. C) The annual percentage rate indicates the amount of simple interest earned in one year. D) The annual percentage rate indicates the amount of interest including the effect of compounding.

d

t/f The term "opportunity" in opportunity cost of capital comes from the fact that any worthwhile opportunity for investment will have a cost: the risk to the capital invested.

false

t/f When there are large numbers of people looking to save their money and there is little demand for loans, one would expect interest rates to be high.

false

Everything else remaining same, under what situation will APR and EAR be equal?

An APR will equal EAR only with annual compounding assuming everything else remains same.

What is the general relationship between the absolute values of APR and EAR for an investment?

The APR of a project will either equal its EAR or be smaller than EAR. The APR will equal EAR with annual compounding for all other compounding intervals the APR will be smaller than EAR.

How are interest and return of principal handled in an amortizing loan payment?

The amount of periodic payments, generally monthly, for most amortizing loans is held constant such that a part goes toward paying interest on the outstanding balance and the rest toward return of principal. Thus this ratio keeps changing over the life of the loan. Initially, when the principal is highest, a major part of the loan goes toward paying interest and a smaller part toward returning the principal. However, as the loan progresses the interest component of the payment increases and the principal component decreases till the loan is fully paid off.

How do we decide on an opportunity cost when we have several opportunities that need to be foregone?

We rank all the foregone opportunities, and opportunity cost is the second best opportunity that we forego. Thus we select the best opportunity and rank all the alternative opportunities and use the cost of the second best opportunity as opportunity cost

Is it possible to analyze cash flows that occur in time intervals that are not exactly equal to a year?

Yes, in real world cash flows may be between any intervals. They may be shorter than a year or longer than a year. Additional care needs to be taken in both cases. For cash flows that have an interval longer than one year, one should be careful to show the years with zero cash flows. Alternately, for those with shorter than a year, one should be careful about modifying the interest rate to match the time interval.

In an effort to maintain price stability, it is expected that the European Central Bank will raise interest rates in the future. Which of the following is the most likely effect of such an action on short-term and long-term interest rates in Europe? A) Long-term interest rates will tend to be higher than short-term interest rates. B) Long-term interest rates will be about the same as short-term interest rates. C) Both long- and short-term interest rates would be expected to fall sharply. D) No relative change in short and long term interest rates could be predicted.

a

What is the effective annual rate (EAR)? A) It is the interest rate that would earn the same interest with annual compounding. B) It is the ratio of the number of the annual percentage rate to the number of compounding periods per year. C) It is the interest rate for an n-year time interval, where n may be more than one year or less than or equal to one year (a fraction). D) It refers to the cash flows from an investment over a one-year period divided by the number of times that interest is compounded during the year.

a

When computing a present value, which of the following is TRUE? A) You should adjust the discount rate to match the interval between cash flows. B) You should adjust the future value to match the present value. C) You should adjust the time period to match the present value. D) You should adjust the cash flows to match the time period of the discount rate.

a

Which of the following best describes the annual percentage rate? A) the quoted interest rate which, considered with the compounding period, gives the effective interest rate B) the effective annual rate, after compounding is taken into account C) the discount rate, when compounded more than once a year or less than once a year D) the discount rate, when effective annual rate is divided by the number of times it is compounded in a year

a

Which of the following situations would result in lowering of interest rates by the banking authority of a country? A) The economy is slowing down. B) Inflation is rising rapidly. C) The level of investment is quite high. D) The rate of savings is quite low.

a

Why, in general, do investment opportunities offer a rate greater than that offered by U.S. Treasury securities for the same horizon? A) Most investment opportunities bear far greater risk than those offered by U.S. Treasury securities. B) The return from U.S. Treasury securities generally attracts less tax than the returns from other investments. C) The opportunity cost of capital for a given horizon is generally based on U.S. Treasury securities with that same horizon. D) U.S. Treasury securities are generally considered to be the best alternative to most investments.

a

What, typically, is used to calculate the opportunity cost of capital on a risk-free investment? A) the best expected return offered in any investment available in the market B) the interest rate on U.S. Treasury securities with the same term C) the interest rate of any investments alternatives that are available D) the best rate of return offered by U.S. Treasury securities

b

Given that the inflation rate in 2006 was about 3.24%, while a short-term municipal bond offered a rate of 2.9%, which of the following statements is correct? A) The purchasing power of investors in these bonds grew over the course of the year. B) The real interest rate for investors in these bonds was greater than the rate of inflation. C) Investors in these bonds were able to buy less at the end of the year than they could have purchased at the start of the year. D) The nominal interest rate offered by these bonds gave the true increase in purchasing power that resulted from investing in these bonds

c

Inflation is calculated as the rate of change in the _______. A) unemployment rate B) Gross Domestic Product C) Consumer Price Index D) risk-free rate

c

Which of the following statements is FALSE? A) The actual return kept by an investor will depend on how the interest is taxed. B) The equivalent after-tax interest rate is r(1 - Θ). C) The highest interest rate for a given horizon is the rate paid on U.S. Treasury securities. D) It is important to use a discount rate that matches both the horizon and the risk of the cash flows.

c

Historically, why were high inflation rates associated with high nominal interest rates? A) Individuals will spend more when they expect their investments to increase in value. B) Growth in investment and savings is encouraged when consumers are judged to be overspending. C) High inflation leads to a decrease in purchasing power and thus increases the attractiveness of investment over consumption in the short term. D) The real interest rate needs to be high enough so that individuals can expect their savings to have greater purchasing power in the future than in the present

d

When the costs of an investment come before that investmentʹs benefits, what will be the effect of a rise in interest rates on the attractiveness of that investment to potential investors? A) It will make it more attractive, since it will increase the investmentʹs net present value (NPV). B) It will make it more attractive, since it will decrease the investmentʹs net present value (NPV). C) It will make it less attractive, since it will increase the investmentʹs net present value (NPV). D) It will make it less attractive, since it will decrease the investmentʹs net present value (NPV)

d

Which of the following statements is FALSE? A) The interest rates that banks offer on investments or charge on loans depend on the horizon of the investment or loan. B) The Federal Reserve determines very short-term interest rates through its influence on the federal funds rate. C) The interest rates that are quoted by banks and other financial institutions are nominal interest rates. D) Fundamentally, interest rates are determined by the Federal Reserve.

d

Which of the following statements is FALSE? A) The opportunity cost of capital is the best available expected return offered in the market on an investment of comparable risk and term of the cash flows being discounted. B) Interest rates we observe in the market will vary based on quoting conventions, the term of investment, and risk. C) The opportunity cost of capital is the return the investor forgoes when the investor takes on a new investment. D) For a risk-free project, the opportunity cost of capital will typically be greater than the interest rate of U.S. Treasury securities with a similar term.

d

Which of the following would be LEAST likely to lower the interest rate that a bank offers a borrower? A) The number of borrowers seeking funds is low. B) The expected inflation rate is expected to be low. C) The borrower is judged to have a low degree of risk. D) The loan will be for a long period of time.

d

t/f For a risk-free investment, the opportunity cost of capital will generally be more than the interest rate offered by U.S. Treasury securities with a similar term.

false

t/f Joe borrows $100,000 and agrees to repay the principal, plus 7% APR interest compounded monthly, at the end of 3 years. Joe has taken out a amortizing loan.

false

t/f The annual percentage rate indicates the amount of interest, including the effect of any compounding

false

t/f The real interest rate is the rate of growth of one's purchasing power due to money invested.

false

t/f Market forces determine interest rates based ultimately on the willingness of individuals, banks, and firms to borrow, save, and lend.

true

t/f Quality adjustments to changes in the CPI most often result in reductions to the inflation rate calculated from it.

true

t/f The opportunity cost of capital is the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted.

true

t/f When you borrow money, the interest rate on the borrowed money is the price you pay to be able to convert your future loan payments into money today.

true