EXAM 2 Finance (CH 4-6)

Question 1

asset

Answer 1

sequence of current and future cash flows (sequence not summation, not past cash flows)

Question 2

future value (FV)

Answer 2

amount of money an investment will grow to, over some period of time at a rate. cash value of an investment at some time in the future

Question 3

future value at end of period t equation

Question 4

compounding

Answer 4

The process of accumulating interest in an investment over time to earn more interest.

Question 5

interest on interest

Answer 5

Interest earned on the reinvestment of previous interest payments.

Question 6

compound interest

Answer 6

Interest earned on both the initial principal and the interest reinvested from prior periods.

Question 7

simple interest

Answer 7

Interest earned only on the original principal amount invested.

Question 8

present value

Answer 8

current dollar value of a future cash flow, value of time at 0 on a time line, amount of money that would have to be invested today at a given interest rate over a specified period to equal the future amount

Question 9

discounting

Answer 9

process of finding present values, reverse of compounding

Question 10

time value of money

Answer 10

money can be invested with expectation of earning a positive rate of return

Question 11

“a dollar received today is worth more than a dollar to be received tomorrow” due to

Answer 11

• todays dollar can be invested so we have one more dollar tomorrow
  -inflation
  -risk (uncertainty of the receipt of that dollar tomorrow)

Question 12

period (t)

Answer 12

length of time

Question 13

present value (PV)

Answer 13

amount of money today or the current value of a future cash flow

Question 14

Interest Rate (r)

Answer 14

the rate you can earn by investing/depoisiting, expressed as a percentage

Question 15

What are the 4 basic patterns of cash flow?

Answer 15

A single amount, an annuity, a perpetuity, a mixed stream

Question 16

a single amount

Answer 16

a lump sum amount either held currently or expected to receive at some future date

Question 17

an annuity

Answer 17

a finite series of equal cash flows that occur at regular intervals

Question 18

a perpetuity

Answer 18

an infinite series of equal cash flows that occur at regular intervals

Question 19

a mixed stream

Answer 19

a stream of unequal periodic cash flows

Question 20

annuities: these cash flows can be ____ of returns earned on investments, or ____ of funds invested to earn future returns

Answer 20

inflows, outflows

Question 21

ordinary annuity

Answer 21

an annuity for which the cash flow occurs at the end of each period

Question 22

annuity due

Answer 22

an annuity for which he cash flow occurs at the beginning of each period

Question 23

in finance, _____ annuity is used more frequently

Answer 23

ordinary

Question 24

perpetuity

Answer 24

a stream of equal cash flows that occur at regular intervals and go on forever

Question 25

if a perpetuity pays an annual cash flow to CF starting one year from now, the PV of the perpetuity is

Answer 25

PV=CF/r

Question 26

mixed stream

Answer 26

a stream of uneven periodic cash flows

Question 27

Annual Percentage Rate (APR)

Answer 27

simple interest rate for a whole year, without taking compounding interest into account (it only takes simple interest into account)

Question 28

Effective Annual Rate (EAR)

Answer 28

also called annual percentage yield, APY, rate earned on an investments for a whole year, taking into account the effects of compounding interest

Question 29

Since APR is a simple interest rate : what is the relationship between APR and rate per period?

Answer 29

APR= interest rate per period* number of periods per year Interest rate per period=APR / number of periods per year

Question 30

Truth in Lending Act of 1968

Answer 30

in the US requires that lenders disclose an APR on virtually all consumer loans. this rate can be displayed on a loan document in a prominent and ambiguous way

Question 31

loan amortization

Answer 31

common type of loan, which the lender may require the borrower to repay parts of the loan amount over time, called amortizing the loan

Question 32

most common way of amortizing a loan

Answer 32

have the borrower make a single, fixed payment (including interest) every period

Question 33

interest rate, time period and cash flow must match

Answer 33

ex: annual periods-annual rate-annual cash flows, monthly periods-monthly rate-monthly cash flows, daily periods-daily rate-daily cash flows

Question 34

sign convention (PMT, PV)

Answer 34

cash inflows are positive (+), cash outflows are negative (-)

Question 35

loan amortization schedule

Answer 35

schedule of equal payments to repay a loan, shows allocation of each loan payment to interest and principal

Question 36

bond

Answer 36

a debt contract indicating that a borrower has borrowed a certain amount of money and promised to repay it in the future under clearly defined terms

Question 37

borrower (issuer)

Answer 37

promises contractually to make periodic payments to lender

Question 38

lender

Answer 38

(bondholder)

Question 39

par value (or face value)

Answer 39

amount borrowed by the borrower and the amount owed to the lender on the maturity date

Question 40

maturity date

Answer 40

time at which a bond becomes due and the principal must be repaid

Question 41

coupon

Answer 41

regular interest payment that the borrower promises to make

Question 42

coupon rate

Answer 42

annual coupon divided by the face value

Question 43

bonds are usually called ____ securities because they represent financial claims with promised cashflows of ________ paid at ______.

Answer 43

"fixed income", "known fixed amount", fixed dates.

Question 44

government bonds (US treasury securities)

Question 45

municipal bonds

Answer 45

bonds issued by state and local governments, interest received is tax-exempt at the federal level, interest usually exempt from state tax in issuing state

Question 46

corporate bonds

Answer 46

bonds issued by corporations, typically pay semiannual coupons, par face value is typically $1000.

Question 47

valuation

Answer 47

process that links risk and return to determine the worth of an asset

Question 48

cash flows (dollar returns)

Answer 48

value of any asset depends on the value of a sequence of current and future cash flows over a specific time period

Question 49

measure of risk

Answer 49

determines the required return (discount rate)

Question 50

a ___ level of risk means a _____ required return (discount rate) in the valuation process

Answer 50

greater, higher

Question 51

the ___ the risk of a cash flow, the ____ its value

Answer 51

greater, lower

Question 52

timing

Answer 52

same amount of cash flows occurring at the different times do have different value

Question 53

what is the price of a bond

Answer 53

present value of the future cash flows promised, discounted at the appropriate interest rate

Question 54

bond value equations

Answer 54

Bond Value = PV(coupons) + PV(par) Bond Value = PV(annuity) + PV(lump sum)