business finance conceptual - exam 1

• The value of a perpetuity with cash flows starting in Year 1, minus the value of a perpetuity with equivalent cash flows starting in Year N+1, where both perpetuities are valued as of Year 0, is nothing more than the present value of an ordinary annuity with equivalent cash flows in Years 1 through N.

• All other factors held constant, the present value of a given annual annuity decreases as the number of discounting/compounding periods per year increases.

true - module 1

• The future value of an annuity due will always be greater than the future value of an equivalent ordinary annuity, whereas the present value of an annuity due will always be less than the present value of an equivalent ordinary annuity

• Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years. One is an ordinary (or deferred) annuity, while the other is an annuity due. Given the mathematics of finance, we know that if interest rates increase, the difference between the present value of the ordinary annuity and the present value of the annuity due will remain the same

false - module 1

Determine which of the following investments will have the highest future value at the end of 5 years, assuming that the effective annual rate for all investments is the same.

A. The investment pays $100 at the end of every year for the next 5 years (a total of 5 payments).

B. The investment pays $50 at the end of every 6-month period for the next 5 years (a total of 10 payments).

C. The investment pays $100 at the beginning of every year for the next 5 years (a total of 5 payments).

D. The investment pays $50 at the beginning of every 6-month period for the next 5 years (a total of 10 payments).

E. The investment pays $500 at the end of 5 years (a total of one payment).

C. The investment pays $100 at the beginning of every year for the next 5 years (a total of 5 payments).

• Except under continuous compounding/discounting, effective annual rates will always be greater than nominal/stated/quoted rates

• If the discount (or interest) rate is positive, the future value of an annuity due will always be less than the future value of an equivalent regular annuity, and the present value of an annuity due will always be less than the present value of an equivalent regular annuity

• For an installment loan, the amount of interest paid each period will increase, whereas the amount of principal paid will decrease. Thus, the total payment each period, as shown on an amortization schedule, will remain the same

least correct - module 1

• Given a long enough holding period, the interest-on-interest that an investor earns in a single period will be greater than the interest earned on the original principal (deposit) during that same period.

most correct - module 1

Which of the following investments will have the highest future value at the end of 5 years (at Year 5)?

A pays $50 at the end of every 6-month period for the next 5 years (a total of 10 payments).

B. B pays $50 at the beginning of every 6-month period for the next 5 years (a total of 10 payments).

C. C pays $500 at the end of 5 years (a total of one payment).

D. D pays $100 at the end of every year for the next 5 years (a total of 5 payments).

E. E pays $100 at the beginning of every year for the next 5 years (a total of 5 payments).

$100 at the beginning of every year for the next 5 years

• An abnormal or inverted yield curve is the same as a downward sloping yield curve.

• If the yield curve is downward sloping, the yield on a 10-year Treasury bond must be less than the yield on an 8-year corporate bond.

• In general, it is said that an upward sloping yield curve indicates that investors expect interest rates to increase in the future. However, this may not necessarily be true if we consider the existence of a maturity premium.

• According to the CAPM/SML, a security with a beta of -2.0 should have the same degree of co-movement with respect to the market as a security with a beta of +2.0, just in the opposite direction.

true - module 2

• Dell Corporation would be involved in a spot market transaction if it were to agree today to sell 500 computers, seven months from now at a price of $500 each, to Best Buy.

• In general we may say that interest rates should fall during an economic boom and rise during an economic recession.

• If the pure expectations theory of the term structure is correct, then an upward sloping yield curve implies a positive maturity risk premium (MRP).

• If the yield curve is upward sloping, the yield on a 2-year corporate bond must be less than the yield on a 5-year Treasury bond.

• Under the Liquidity Premium theory of the term structure, and assuming a positive maturity risk premium, we should never observe a flat or downward sloping yield curve.

false - module 2

• Treasury Bonds and Municipal Bonds are similar in that they are all issued by federal, state, and local governments. Because of this, their yield to maturity does not include a default risk premium.

• Once a bond is issued by a firm, both its coupon rate and yield-to-maturity are fixed for the life of the bond; thus the name, fixed income security.

• If a 10-year bond is selling at a premium, then its price is higher than its par value, and this price must decrease in every future period.

• Because callable bonds can be called before the maturity date of the bond, and investors therefore will lose the coupon payments between the call date and the maturity date if the bond is called, the yield-to-call must be less than the yield-to-maturity

• Assume that you buy a bond at par but do not hold it until it matures. If reinvestment rates decrease right after you purchase the bond, then your realized compounded yield should be less than the bond’s yield-to-maturity, whereas if reinvestment rates increase right after you purchase the bond, then your realized compounded yield should be greater than the bond’s yield-to-maturity.

• The duration of a zero-coupon bond will always be greater than it maturity, while the duration of a coupon paying bond will always be less than its maturity.

• Even though so called “no-no” bonds pay no coupon and have no yield, this is the limit. It would be impossible for anyone to issue a bond with a negative yield.

• A bond’s yield-to-maturity is sometimes referred to as a promised yield. That is, if you hold the bond until it matures, you are guaranteed (promised) to earn the yield that existed when you originally bought the bond

false - module 3

• If a firm privately places its debt (so that there is no flotation expense), then the yield to maturity on this debt will be equal to the firm’s before-tax cost of debt.

• The duration of a zero-coupon bond will always be equal to its maturity, while the duration of a coupon paying bond will be less than its maturity.

• Assume that you buy a bond at par and hold it until it matures. If reinvestment rates decrease right after you purchase the bond, then your realized compounded yield should be less than the bond’s yield-to-maturity, whereas if reinvestment rates increase right after you purchase the bond, then your realized compounded yield should be greater than the bond’s yield-to-maturity.

• A bond’s yield to maturity is also, at times, referred to as its promised yield. That is, if interest rates (yields or reinvestment rates) do not change over the life of the bond, and the bond is held until maturity, then this is the interest rate (realized compounded yield) that you are promised to earn.

true - module 3

• Assume that two bonds have the same time to maturity, but because of the pattern of their cash flows, one bond can be labeled an “earlier” bond while the other is labeled a “later” bond. If we observe a downward-sloping yield curve, then the “earlier” bond will have a lower yield-to-maturity than the “later” bond.

• Regardless of the size of the coupon payment, the price of a bond moves in the same direction as interest rate movements (investors’ required rates of return).

least correct - module 3

• The longer the maturity of a bond, the more sensitive the bond will be to changes in the discount rate (i.e., the investors’ required rate of return). If interest rates go up, all other factors the same, a bond with a longer time to maturity will have a larger capital loss than an equivalent bond with a shorter time to maturity.

• Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year. One year from now, Bond A's price will be higher than it is today.

• Relative to coupon-bearing bonds, zero coupon bonds have more interest rate risk but less reinvestment rate risk.

• The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things equal and held constant. This is because, all other things equal, a high-coupon bond has a shorter duration than a low-coupon bond.

most correct - module 3