FINANCE EXAM 2

Bonds issued by state and local governments are called _______ ______.

municipal bonds

annuity due

payments occur at the beginning of each period

Ordinary Annuities

payments occur at the end of each period.

The current value of a future cash flow discounted at the appropriate rate is called the _____ value.

present

The original amount of a loan is termed the loan ___________.

principle

compounding

the process of leaving your money and any accumulated interest in an investment for more than one period, thereby reinvesting the interest

If a $1,000 par value bond is trading at a premium, the bond is:

trading for more than $1,000 in the market

True or false: If you invest at a rate of r for two periods, under compounding, your investment will grow to (1+r)^2 per dollar invested.

true

True or false: Longer-term bonds have greater interest rate sensitivity because a large portion of a bond's value comes from the face amount.

true

Debt

• Not an ownership interest • No voting rights • Interest is tax-deductible • Creditors can legally claim the assets if interest or principal payments are missed • Excess debt can lead to financial distress and bankruptcy

Pure Discount Loans

(Treasury bills are excellent examples) •Principal amount is repaid at maturity day. •No periodic interest payments

Amortized Loan with Fixed Payment

(car loans and house loans are examples) •Each payment covers the interest expense plus reduces principal •Fixed payments made each period •Each payments includes periodic interest and part of principal

Interest-Only Loans

(corporate bonds are excellent examples) •Borrowers pay interest each period and repay the entire principal at some point in the future. No principal will be prepaid before maturity day.

Periodic Rate

- is amount of interest charged each period, e.g. monthly or quarterly. - PR = nominal rate/M, where M is the number of compounding periods per year. M = 4 for quarterly and M = 12 for monthly compounding. - is used in calculations and shown on time lines.

Simple interest

- is computed on the original investment for every period - interest on Principal only

2 Types of Annuity

1. Ordinary Annuity 2. Annuity Due

time value of money

A dollar received today is more valuable than a dollar received in the future because you can invest that dollar today and earn interest.

Nominal Rate (APR)

An annual rate that ignores compounding effects. is stated in contracts, quoted by banks and brokers. When talking about nominal rate, periods must also be given, e.g. 4% quarterly or 4% daily interest - NAMED OR STATED INTEREST RATE

Interest rate(price) risk

As interest rates rise, bond prices fall (and vice versa) •Thus, investors who hold bonds will experience a decline in the market value of their bonds during a period of rising interest rates

Which of the following processes can be used to calculate the future value of multiple cash flows?

Compound the accumulated balance forward one year at a time Calculate the future value of each cash flow first and then sum them

Which of the following is not a difference between debt and equity?

Equity is publicly traded while debt is not

Coupon rate vs Discount Rate

If coupon rate > discount rate, then bond price>par value--'Premium Bond' If coupon rate < discount rate, then bond price<par value--'discount Bond' If coupon rate = discount rate, then bond price=par value--'par Bond'

Default risk

If the bond issuer defaults, investors receive less than the promised return. Bond ratings are designed to reflect the probability of a bond issue going into default

compound interest

Interest earned on both the initial principal and the interest reinvested from prior periods, which includes interest on principal and interest on interest. = interest on principal + interest on interest.

perpetuity

Is a payment stream of the same amount at regular fixed time intervals that continues forever

Annuity

Is a series of equal payments for a specified period of time EX: YEARLY ALLOWANCE

Suppose you buy a 7 percent coupon, 20-year bond today when it's first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why?

Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall. This is because the fixed coupon payments determined by the fixed coupon rate are not as valuable when interest rates rise-hence, the price of the bond decreases.

Loan Types

Pure discount loans, interest-only loans, and amortized loans.

Reinvestment risk

Reinvestment risk is the concern that r will fall, and future cash flows will have to be reinvested at lower rates, hence reducing income

What are the two unique features of a U.S. federal government bond?

U.S. Treasury issues are considered to be default-free. U.S. Treasury issues are exempt from state income taxes.

Effective Annual Rate (EAR)

When interest rates have different compounding periods (semi-annually, quarterly, monthly, daily, continuously, etc.), you need to compare the rates by converting them to a common base. This common base interest rate for comparison is called EAR. EAR is Used to compare returns on investments with different payments per year. When comparing savings accounts, you should select the account that has the highest EAR. - EAR increases with the frequency of compounding - EAR, not APR, represents the true cost to a borrower or return to a lender/depositor

A bond's coupon payment is:

a fixed amount of interest that is paid annually or semiannually by the issuer to its bondholders

Bond ratings

are designed to reflect the probability of a bond going into default

Bond

are issued by corporation (corporate bond), local government (municipal bond) or the US government (treasury bond). When a corporation (or government) wishes to borrow money from the public on a long-term basis, it usually does so by issuing, or selling, debt securities that are generically called bonds.

Future value is the ________ value of an investment at some time in the future.

cash

When interest rates in the market rise, we can expect the price of bonds to ____.

decrease

True or false: The process of leaving your money and any accumulated interest in an investment for more than one period is called multiplied interest. True false question.

false

interest on interest

interest earned on the reinvestment of previous interest payments.

Yield to Maturity (YTM)

is an implied discount rate. It is the rate of return that equates the current price of the bond to the present value of all the remaining promised payments of the bond

An ordinary annuity consists of a(n) ________ stream of cash flows for a fixed period of time.

level

Equity

• Ownership interest • Common stockholders vote to elect the board of directors and on other issues • Dividends are not tax deductible • Dividends are not a liability of the firm until declared. Stockholders have no legal recourse if dividends are not declared • An all-equity firm cannot go bankrupt (Bankruptcy occurs when the firm does not have enough resources to pay its interest and principle obligations on time.)