Week 2 Questions

What is an opportunity cost rate?

Define each of the following terms:


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

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?

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?

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.

Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain.

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

“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.

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?

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.

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.

Answer preview What is an opportunity cost rate?


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