Interest Rates, Bonds, Capital Budgeting & Related Topics – Comprehensive Review

230 question-and-answer flashcards covering mortgage math, bonds, interest rates, risk, taxes, forward rates, capital budgeting fundamentals, incremental free cash flow, NPV, IRR, sensitivity analysis, and related financial concepts drawn from the lecture transcript.

What does APR stand for?

Annual Percentage Rate

For a mortgage quoted with monthly compounding, how is the periodic rate calculated?

Divide the APR by 12

Define EAR.

Effective Annual Rate – the actual annual return after compounding

Continuous compounding converts an APR to EAR using which formula?

EAR = e^{APR} – 1

In continuous compounding, what is the mathematical constant e approximately equal to?

2.71828

What is an amortization schedule?

A table showing each loan payment’s allocation between interest and principal

How many payments per year are made on a bi-weekly mortgage?

26

What is the primary advantage of making mortgage payments bi-weekly?

You repay principal faster, shortening the term and lowering interest paid

A mortgage’s outstanding balance after k payments equals what?

Present value of remaining payments discounted at the loan’s periodic rate

What does refinancing a mortgage mean?

Taking a new loan to pay off the existing one, usually at a lower rate

How is a zero-coupon bond priced?

PV = Face Value / (1+YTM)^n

What is a pure-discount bond?

Another term for a zero-coupon bond

The yield to maturity (YTM) of a risk-free zero-coupon bond equals what?

The risk-free interest rate for that maturity

What is the relationship between bond prices and yields?

Prices fall when yields rise and vice versa

What are coupon bonds?

Bonds that pay periodic interest plus face value at maturity

Explain ‘yield curve’.

A graph showing yields to maturity versus bond maturities

Define spot interest rate.

The YTM of a default-free zero-coupon bond for a given maturity

Why might a bond trade at a premium?

Its coupon rate exceeds its YTM

Define duration.

A measure of a bond’s price sensitivity to interest rate changes

How does coupon rate affect duration?

Higher coupons ↓ duration; lower coupons ↑ duration

What is a credit spread?

Difference between corporate bond yield and Treasury yield of same maturity

Why do corporate bonds have higher yields than Treasuries?

Compensation for default risk and lower liquidity

What are investment-grade bonds?

Bonds rated BBB-/Baa3 or higher

Define speculative or junk bond.

Bond rated below investment grade due to higher default risk

What is a forward rate?

An interest rate fixed today for a loan that will occur in the future

Formula to derive 1-year forward rate f₂ from zero rates r₁ and r₂?

(1+r₂)^2 / (1+r₁) – 1

Opportunity cost of capital equals what in efficient markets?

Expected return on the best alternative investment with similar risk

Net Present Value (NPV) decision rule?

Accept projects with positive NPV

Why are sunk costs ignored in capital budgeting?

They cannot be recovered and don’t change with the decision

Define IRR.

Discount rate that makes a project’s NPV equal zero

When can IRR and NPV conflict?

Non-conventional cash flows, mutually exclusive projects, or scale differences

Payback period is what?

Time until cumulative cash inflows equal initial outlay

Main weakness of payback rule?

Ignores time value of money and cash flows beyond cut-off

What is incremental cash flow?

Cash flow with the project minus cash flow without the project

Capital expenditures (CapEx) appear in NPV analysis as what?

Cash outflows when incurred

Depreciation affects cash flow via what?

Depreciation tax shield

Depreciation tax shield formula?

Tax Rate × Depreciation Expense

Straight-line depreciation divides cost by what?

Useful life

Under MACRS, depreciation is?

Accelerated; larger deductions early, smaller later

How are increases in net working capital treated?

As cash outflows (use of cash)

Recovery of NWC at project’s end is treated how?

Cash inflow

What is cannibalization?

New product sales displace sales of existing products

Explain opportunity cost in capital budgeting.

Value of a resource in its best alternative use

Define continuation (terminal) value.

PV at horizon of cash flows beyond explicit forecast period

Scenario analysis involves what?

Evaluating NPV under different joint assumptions

Sensitivity analysis varies what?

One input at a time to see its impact on NPV

Break-even analysis finds what?

Input value that sets NPV to zero

What is the depreciation schedule under bonus depreciation (TCJA 2017)?

100% expensed immediately for qualified assets (until phase-out)

Tax loss carryforward allows what?

Use of past net operating losses to offset future taxable income

Formula for free cash flow (FCF)?

FCF = Unlevered NI + Depreciation – CapEx – ΔNWC

Unlevered net income excludes what?

Interest expenses

Why exclude financing costs in project cash flows?

Financing is captured in discount rate, not operating cash flows

Capital rationing leads to use of what metric?

Profitability Index (PI)

Profitability Index formula?

PI = NPV / Resource Consumed

When is PI fully reliable?

Single resource and projects exhaust resource exactly

Explain incremental IRR.

IRR of differences in cash flows when switching between projects

Multiple IRRs occur when?

Cash flow sign changes more than once

What is a default-free bond?

Bond issued by entity with no risk of default (e.g., U.S. Treasury)

Explain clean price.

Bond price excluding accrued interest

Dirty price equals what?

Bond’s cash price including accrued interest

LIBOR stands for?

London Interbank Offered Rate

TED spread measures what?

Difference between LIBOR and T-bill rate; gauges credit risk

Define sovereign bond.

Bond issued by a national government

Inflating away debt means what?

Repaying with currency worth less due to inflation

Continuous cash flows can be approximated with what convention?

Mid-year discounting

A perpetuity’s PV formula?

PV = C / r

Growing perpetuity PV?

PV = C₁ / (r – g)

Mid-year convention discounts by?

Half a year less than year-end

What is capital budgeting?

Process of analyzing and selecting long-term investments

What is a mutually exclusive project?

Choosing one precludes selection of the others

Capital structure irrelevance (MM) implies what for NPV?

NPV depends only on asset cash flows, not financing mix

Define hurdle rate.

Minimum acceptable IRR set by management

Short-term yield spreads widen in crisis because?

Rising perceived default/liquidity risk

Sovereign default risk impacts yields via what?

Higher required returns to compensate investors

Treasury STRIPS represent what?

Separate trading of interest and principal of U.S. bonds

Discount factor equals what?

1 / (1 + r)^t

What is convexity in bond pricing?

Measure of curvature of price-yield relation

Duration in years approximates what?

Percentage price change per 1% yield change divided by yield

APR with daily compounding convert to EAR how?

EAR = (1 + APR/365)^{365} – 1

For EAR to APR monthly?

APR = (1+EAR)^{1/12} – 1, then ×12

Mortgage points are what?

Upfront fees expressed as percentage of loan amount

Paying points lowers what?

Contract interest rate

Break-even horizon for points calculated how?

Extra upfront cost / monthly payment savings

Annuity PV factor formula?

(1 – 1/(1+r)^n) / r

Annuity payment formula?

PMT = PV × r / (1 – 1/(1+r)^n)

Incremental NWC in year t equals what?

NWCt – NWC{t-1}

If sale price < book value, tax effect is?

Tax credit (negative tax) on loss

MACRS 5-year property depreciates what % in first year?

20%

Payback ignores what key concept?

Time value of money

Capital gains tax usually lower or higher than ordinary income?

Lower

What is leverage?

Use of debt financing to amplify returns

Reinvestment rate assumption relates to what metric?

IRR assumes cash flows reinvested at IRR

Modified IRR (MIRR) fixes what flaw?

Unrealistic reinvestment assumption of IRR

When is NPV profile upward sloping?

When negative cash flows follow positive ones

What is deferred tax asset?

Credit on balance sheet for future tax reductions

Define market yield.

Return demanded by investors in competitive markets

Pricing a coupon bond uses which formula?

PV = Σ CPN/(1+y)^t + FV/(1+y)^n

Callable bond feature?

Issuer can repurchase before maturity

Puttable bond?

Holder can force issuer to buy back before maturity

Indexed bond adjusts payments based on what?

Inflation index like CPI