Business Finance Chapter 5

Which one of the following has the highest effective annual rate?

6 percent compounded monthly

Travis is buying a car and will finance it with a loan which requires monthly payments of $265 for the next 4 years. His car payments can be described by which one of the following terms?

Annuity

You are comparing two annuities. Annuity A pays $100 at the end of each month for 10 years. Annuity B pays $100 at the beginning of each month for 10 years. The rate of return on both annuities is 8 percent. Which one of the following statements is correct given this information?

Annuity B has both a higher present value and a higher future value than Annuity A.

Janis just won a scholarship that will pay her $500 a month, starting today, and continuing for the next 48 months. Which one of the following terms best describes these scholarship payments?

Annuity due

Which one of the following is an ordinary annuity, but not a perpetuity?

$25 paid weekly for one year, starting one week from today

Scott borrowed $2,500 today. The loan agreement requires him to repay $2,685 in one lump sum payment one year from now. This type of loan is referred to as a(n):

pure discount loan.

Lee pays one percent per month interest on his credit card account. When his monthly rate is multiplied by 12, the resulting answer is referred to as the:

annual percentage rate

A loan has an APR of 8.5 percent and an EAR of 8.5 percent. Given this, the loan must:

charge interest annually

Which one of the following statements is correct?

The EAR, rather than the APR, should be used to compare both investment and loan options.

The Jones Brothers recently established a trust fund that will provide annual scholarships of $12,000 indefinitely. These annual scholarships can best be described by which one of the following terms?

Perpetuity

Which one of the following statements is true concerning annuities?

All else equal, an increase in the discount rate decreases the present value and increases the future value of an annuity.

What does it mean when a loan is amortized? Explain how amortization methods can vary from one loan to another.

Amortization means that a portion of the loan principal is repaid with each loan payment. The amortization method can be based on equal principal payments or varying principal payments.

Bill just financed a used car through his credit union. His loan requires payments of $275 a month for 5 years. Assuming that all payments are paid timely, his last payment will pay off the loan in full. What type of loan does Bill have?

Amortized

Letitia borrowed $6,000 from her bank 2 years ago. The loan term is 4 years. Each year, she must repay the bank $1,500 plus the annual interest. Which type of loan does she have?

Amortized

Which one of the following statements concerning annuities is correct?

An annuity due has payments that occur at the beginning of each time period.

Which one of the following qualifies as an annuity?

Auto loan payment

A perpetuity in Canada is frequently referred to as which one of the following?

Consul

Which one of the following will decrease the present value of an annuity?

Decrease in the annuity payment

Explain the similarities and differences among an ordinary annuity, an annuity due, and a perpetuity.

Differences: The ordinary annuity has payments that occur at the end of each time period for a stated number of time periods. An annuity due has payments that occur at the beginning of each time period for a stated number of time periods. A perpetuity has unending payments. Similarities: Both annuities and perpetuities have equal payments occurring in equal time intervals.

Anna pays 1.5 percent interest monthly on her credit card account. When the interest rate on that debt is expressed as if it were compounded only annually, the rate would be referred to as the:

Effective annual rate

Which one of the following can be classified as an annuity but not as a perpetuity?

Equal annual payments for life

Which one of the following can NOT be computed?

Future value of a perpetuity

Which of the following will increase the present value of an annuity, all else held constant? I. Increase in the number of payments II. Increase in the interest rate III. Decrease in the interest rate IV. Decrease in the payment amount

I and III only

Which of the following characteristics apply to a perpetuity? I. Constant cash flow dollar amount II. Unequal cash flow dollar amount III. Limited time period IV. Infinite time period

I and IV only

Travis borrowed $10,000 four years ago at an annual interest rate of 7 percent. The loan term is 6 years. Since he borrowed the money, Travis has been making annual payments of $700 to the bank. Which type of loan does he have?

Interest only

You just borrowed $3,000 from your bank and agreed to repay the interest on an annual basis and the principal at the end of 3 years. What type of loan did you obtain?

Interest-only

Consider an ordinary annuity and the variables that are related to that annuity. For each of the following sets of variables, identify whether the relationship between the two variables is direct (D) or inverse (I). Assume all other variables are held constant.

Present value and number of payments D Present value and interest rates I Number of payments and future value D

Chandler Tire Co. is trying to decide which one of two projects it should accept. Both projects have the same start-up costs. Project 1 will produce annual cash flows of $52,000 a year for 6 years. Project 2 will produce cash flows of $48,000 a year for 8 years. The company requires a 15 percent rate of return. Which project should the company select and why?

Project 2; because the present value of the cash inflows exceeds those of Project 1 by $18,598.33

Cindy is taking out a loan today. The cash amount that she will receive today is equal to the present value of the lump sum payment which she will be required to pay 2 years from today. Which type of loan is this?

Pure discount

First Bank offers personal loans at 7.6 percent compounded monthly. Second Bank offers similar loans at 7.75 percent compounded semi-annually. Which one of the following statements is correct concerning these loans?

The First Bank offers the best deals on loans

You are comparing three investments, all of which pay $100 a month and have an 8 percent interest rate. One is ordinary annuity, one is an annuity due, and the third investment is a perpetuity. Which one of the following statements is correct given these three investment options?

The present value of the perpetuity has to be higher than the present value of either the ordinary annuity or the annuity due.

Which one of the following features distinguishes an ordinary annuity from an annuity due?

Timing of the annuity payments

Christie is buying a new car today and is paying a $500 cash down payment. She will finance the balance at 7.25 percent interest. Her loan requires 36 equal monthly payments of $450 each with the first payment due 30 days from today. Which one of the following statements is correct concerning this purchase? A. The present value of the car is equal to $500 + (36 × $450).

To compute the initial loan amount, you must use a monthly interest rate.

Which one of the following is an example of a perpetuity?

Trust income of $1,200 a year forever

When comparing savings accounts, you should select the account that has the:

highest effective annual rate.

The stated interest rate is the interest rate expressed:

in terms of the interest payment made each period.

A credit card has an annual percentage rate of 12.9 percent and charges interest monthly. The effective annual rate on this account:

will be greater than 12.9 percent.