Principle of Finance
Define each of the following terms:
PV; I; INT; ; ; ; PMT; M;
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
(4-2)
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?
(4-3)
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?
(4-4)
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.
(4-5)
Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain.
Questions
(5-1)
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, ; nominal risk-free rate of interest,
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
(5-2)
“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.
(5-3)
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?
(5-4)
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.
(5-5)
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.
