FIN 315 EXAM #3 PREP (CHAPTERS 5 & 6)
[Review Question 5-6] What effect does increasing the required return have on the present value of a future amount? Why?
A increase of the required return will increase the present value of a future amount. More money in the future becomes more money required in the present.
annual percentage yield
the actual interest rate an account pays per year
Future Value (FV)
the amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate
effective (true) annual rate (EAR)
the annual rate of interest actually paid or earned
mixed stream of cash flows
the cash flows are not all the same amount and/or they are not received at regular intervals
discounting cash flows
the process of finding present values; the inverse of compounding interest
simple interest
interest paid on the principal alone
[Review Question 6-4] Briefly describe the following theories of the general shape of the yield curve: (a) expectations theory, (b) liquidity preference theory, and (c) market segmentation theory
(a) Expectations theory states that the yield curve is influenced by the interest rate expectations. So when the yield curve is up, that means investors expect the rates to rise and vice versa. A self fulfilling prophecy. (b) Liquidity preference theory means that all things being equal investors want short term securities while issuers want to sell long-term. (c) Segmentation theory thinks that both markets are separate from one another and an upward sloping curve means demand is up in both segments.
[Review Question 5-4] What effect would a decrease in the interest rate have on the future value of a deposit? What effect would an increase in the holding period have on future value?
A decrease on the rate would decrease the future value they have a positive correlation. An increase on the holding periods would also increase the future value as the value has more time to gain interest.
[Review Question 6-3] For a given class of similar-risk securities, what does each of the following yield curves reflect about interest rates: (a) a downward sloping (b) upward sloping and (c) flat.
A downward slope is a normal curve and means longer-term interest rates are higher than shorter term. Upward slopes mean the inverse, shorter term has higher than long term. Flat means rates aren't different regarding maturity.
[Review Question 5-14] What is a perpetuity? Why is the present value of a perpetuity equal to the annual cash payment divided by the interest rate? Why doesn't the chapter provide an equation showing you how to calculate the future value of a perpetuity?
A perpetuity is an annuity with no end date. Due to its infinite nature the future value can't be calculated and the present value is simply the interest rate established at the start.
loan amortization schedule
A schedule of equal payments to repay a loan. It shows the allocation of each loan payment to interest and principal.
[Review Question 5-2] Define and differentiate among the three basic patterns of cash flow: (1) a single amount, (2) an annuity, and (3) a mixed stream.
A single amount is a lump sum held or expected. An annuity is a series of equal deposits. A mixed stream is like an annuity but the amounts aren't equal. These 3 differ based on the size and frequency of the deposits into whatever account they are associated with.
[Review Question 6-5] List and briefly describe the potential issuer and issue related risk components that are embodied in the risk premium. Which are the purely debt specific risks?
Business risk - is it good for business? financial risk - will it pay well? Interest rate risk - could the rate change? liquidity risk - how quickly can I turn this into cash? provision risk - Is what I set aside enough? debt-specific risks: default risk - Will I ever get paid back contractual provision risk - How much am I required to set aside for this?
[Review Question 5-28] How can you determine the unknown number of periods when you know the present and future values -single amount or annuity and the applicable rate of interest?
By knowing the rate and the PV and FV you use the NPER function in Excel and plug in the known info, it'll tell you how many periods it'd take.
[Review Question 5-26] How can you determine the size of the equal, end-of-year deposits necessary to accumulate a certain future sum at the end of a specified future period at a given annual interest rate?
By using the PMT function in Excel and with the knowledge of the rate, future value, and # of periods you can find precisely what should be paid each period.
[Review Question 5-27] Describe the procedure used to amortize a loan into a series of equal periodic payments.
By using the PMT, FV, NPER functions in Excel you can piece together exactly what kind of schedule is needed. For classroom purposes all but one of these will be provided and we are to find the missing data.
[Review Question 6-13] What are the three key inputs to the valuation process?
Cash flow, timing, and measure of risk
[Review Question 5-20] What effect does compounding interest more frequently than annual have on (a) future value and (b) the effective annual rate (EAR)? Why?
Compounded interest accrues larger and faster with more periods to build the principle. (a) the future value increases dramatically as you increase the number of periods. (b) The effective annual rate or the ACTUAL rate of return is also much higher as that rate takes into consideration compounded interest.
[Review Question 6-9] What is the conversion feature? A call feature? What are stock purchase warrants?
Conversion feature is the bondholders ability to convert their bonds into the issuers common stock. A call feature is the ability of the issuer to repurchase their own bonds prior to maturity. Stock purchase warrants give the holders of said warrant the ability to buy a certain about of common stock at a certain price for a certain time.
Annual Percentage Rate (APR)
Cost of borrowing money on an annual basis; takes into account the interest rate and other related fees on a loan.
Timeline
Depicts the cash flows associated with a given investment.
[Review Question 5-12] How can the formula for the future value of an annuity be modified to find the future value of an annuity due?
During the Excel process type 1 at the end to signify it's annuity due.
[Review Question 6-11] Compare the basic characteristics of Eurobonds and foreign bonds
Eurobonds are bonds issued by an international borrower in currency's other than where the bond was purchased. To contrast the foreign bond, which is purchased and used only in the country it was purchased in.
[Review Question 6-8] How is the cost of bond financing typically related to the cost of short term borrowing? In addition to the maturity of a bond, what other major factors affect its cost to the issuer?
Financing costs are greater than the costs of short term borrowing. THe factors outside of maturity that affect the bonds cost are it's size, the issuer's risk, and the cost of the money.
[Review Question 5-11] What is the most efficient way to calculate the present value of an ordinary annuity?
For my purposes, Excel's PV function is the most efficient.
ordinary annuity
If the first payment occurs at the end of the period
[Review Question 5-18] How do you calculate the future value of a mixed stream of cash flows? How do you calculate the present value of a mixed stream?
In Excel! To get the Future Value find the NPV of the mixed stream and use that value in the FV function. To find the present value just take the NPV.
[Review Question 6-12] Why is it important for financial managers to understand the valuation process?
Investments that seems wise may not always be the best bet. Knowing how to assign values amidst varying risks helps with the decision making process.
[Review Question 6-14] Does the valuation process apply only to assets that provide an annual cash flow? Explain.
No it applies to things that pay annually, semiannually, intermittently, or only once. All methods come with varying risk but are still sources of value regardless.
[Review Question 6-19] As a risk averse investor, would you prefer bonds with a short or long period until maturity? Why?
Short term is better because short term isn't influenced by market shifts as much and therefore carries less risk.
[Review Question 6-7] Differentiate between standard debt provisions and restrictive covenants included in a bond indenture. What are the consequences if a bond issuer violates any of these covenants?
Standard debt provisions are business rules the bond issuer must follow. Restrictive covenants are rules the borrower must follow in order to mitigate risk on the issuer. Violations give the issuer the right to demand immediate repayment of any debt.
[Review Question 5-21] How does the future value of a deposit subject to continuous compounding compare to the value obtained by annual compounding?
The FV increases with continuous compounding as the future value takes into consideration how many periods will be in the payment life.
[Review Question 6-20] What is a bond's yield to maturity? Briefly describe the use of a financial calculator and the use of an excel spreadsheet for finding YTM. Why is the YTM a good measure of the required return on a bond?
The YTM is the compound annual rate of return earned on a bond purchased on a given day and held to maturity. In Excel list the cash flows and use the IRR function.
principal
The amount of money borrowed
[Review Question 6-10] What is the current yield for a bond? How are bond prices quoted? How are bonds rated, and why?
The annual interest payment divided by the bonds current price equals it's yield. Bond prices are more closely held and aren't available easily, they're quoted by company name, coupon rate, maturity date, price, and yield to maturity.
[Review Question 5-10] What is the difference between and ordinary annuity and an annuity due? Which is more valuable? Why?
The difference lies in when the money is paid. Ordinary annuities are paid at the end of the year while annuity dues are paid at the beginning. The annuity due has the greater value, due in part to the extra year of interest.
[Review Question 5-22] Differentiate between a nominal annual rate and an effective annual rate (EAR). Define annual percentage rate (APR) and annual percentage yield (APY).
The nominal rate is the quoted rate which does not take compounding into account. The Effective rate does take compounding into account and that's why it's the TRUE rate. APR is nominal and APY is effective. They are used to either make rates charged seem lower or make savings seem larger.
[Review Question 6-16] What procedure is used to value a bond that pays annual interest? Semiannual interest?
The present value function in Excel, for both.
[Review Question 5-5] What is meant by "the present value of a future amount"? What is the general equation for present value?
The present value of a future amount is what X amount in the future is worth today. The equation for present value is Future Value divided by (1+rate) raised to the number of periods.
[Review Question 5-1] What is the difference between future value and present value? Which approach is generally preferred by financial managers?
The present value represents what must be invested NOW to guarantee a desired payment in the future. Future value is the amount a investment will grow to over time. Managers typically adopt the present value approach.
[Review Question 6-1] What is the real rate of interest? Differentiate it from the nominal rate of interest.
The real rate of interest is the nominal rate - expected inflation. It differs from the nominal rate in that it factors inflation into it.
[Review Question 6-1] What is the term structure of interest rates, and how is it related to the yield curve?
The term structure of interest rates is the relationship between maturity and rates of bonds with similar levels of risk. The yield curve is what the name of graphing that relationship.
[Review Question 6-15] Define and specify the general equation for the value of any asset, v0
The value of the asset at time zero is found by dividing the sum of each cash flow in that year by 1 + the required rate of return) raised to the power of the year.
[Review Question 6-18] If the required return on a bond differs from its coupon rate, describe the behavior of the bond price over time as the bond moves toward maturity.
The value of the bond will approach par value as time goes on and the maturity dates gets closer.
[Review Question 5-7] How are present value and future value calculations related?
They are inverses of one another. Present values divides future value by the rate and periods while Future value multiplies present value by the same units.
Compound Interest
interest earned on both the principal amount and any interest already earned
[Review Question 5-13] How can the formula for the present value of an ordinary annuity be modified to find the present value of annuity due?
Type 1 in the Excel formula. For FIN 315 we won't be manually solving these.
[Review Question 6-6] What are typical maturities, denominations, and interest payments of a corporate bond? What mechanisms protect bondholders?
Typical maturity is 10 to 30 years. Denominations are $1000. Interest payments come semiannually. The bond indenture provides rights to both the holder and issuer of a bond.
Present Value (PV)
Value today of a future cash flow
[Review Question 6-17] What relationship between the required return and the coupon rate will cause a bond to sell at a discount? At a premium? At its par value?
When return > rate value is less than par and sold at a discount. Therefore when return < rate it's sold at premium and when return = rate it goes for par.
[Review Question 5-3] How is the compounding process related to the payment of interest on savings? What is the general equation for future value?
With compounding the interest accrued is included in the principal. Future value is the Present Value * ( 1+Rate) raised to the number or periods.
Single amount cash flow
a lump sum amount either held currently or expected at some future date
annuity
a series of equal regular deposits
annuity due
an annuity for which the cash flows occur at the beginning of the period
perpetuity annuity
an annuity with an infinite life calculated by dividing the cash flow of period 1 by the rate or return
nominal (stated) annual rate
contractual annual rate of interest charged by a lender or promised by a borrower
Loan Amortization
with each payment, the interest portion covered decreases and principal portion covered increases