Business Finance Exam 2

simple interest

interest earned only on the original principal amount invested.

compound interest

interest earned on the interest reinvested from prior periods.

interest on interest

interest earned on reinvestment of previous interest payments

how do investments grow

simple interest

compound interest

annuity

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

ordinary annuity

cash flows occur at end of each period

annuity due

cash flows occur at the beginning of each period

perpetuity

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

example of ordinary annuity

student/auto/mortgage loans

example of annuity due

rent

example of perpetuity

consols

dividends on preferred stock

in annuity due each payment is moved forward one period

one less period to be discounted

one extra period to be compounded

EAR stands for

effective annual rate

effective annual rate represents…

the actual rate paid (or received) after accounting for compunding

APR stands for

annual percentage rate

annual percentage rate

the quoted interest rate that does not account for compounding

what are lenders required by law

to disclose the APR to potential borrowers

what to compute and use for comparison of different compounding periods

EAR (effective annual rate)

installment loans

provides a borrower with a lump sum of money that is repaid over a fixed period through scheduled, equal payments, or "installments”

bond

interest-only loan with principal repayment at maturity of the loan

face value (or par value)

principal payment of a bond that is repaid at the end of the term

coupon

annual or semi-annual payments to the bondholder

maturity due

the specified date on which the principal amount of a bond is repaid

yield of maturity (or yield)

the rate of return on a bond assuming it is held until maturity

yield to maturity (YTM) points

the rate implied by the current bond price

the return on a bond assuming it is held until maturity

finding the YTM requires…

trial and error if you do not have a calculator

par bond

price = face value

discount rate

price below face value

premium bond

price above face value

2 interest rate risks

price risk

reinvestment risk

interest risk

risk that arises for existing bondholders due to fluctuating interest rates

price risk 

interest rates increases = bond prices decreases

interest rates decreases = bond prices increases

interest rates and bond prices

are inversely (or negatively) related

long-term bonds have

more price risk than short-term bonds

low coupon rates bonds have

more price risk than high coupon rate

reinvestment risk

uncertainty concerning rates at which cash flows can be reinvested

short-term bonds have more reinvestment rate risk

than long-term bonds

high coupon rate bonds have more reinvestment rate risk

than low coupon rate bonds

bebt (bond) characteristics

• not an ownership interest

• no voting rights

• interest is tax deductible

• creditors have legal recourse if interest or principal paymentd are missed.

• excess debt can lead to financial distress and bankruptcy

equity characteristics

• ownership interest

• common stockholders vote to elect the board of directors and on other issues.

• dividends are not tax deductible

• dividends are not a liability of the firm until declared. Stockholders have no legal recourse if dividends are not declared

• an all-equity firm cannot go bankrupt

bond indenture

a legal contract between the issuing company and the bondholders

the bond indentures include

the basic terms of the bonds

seniority

security

call provisions

the basic terms of the bonds

face value

coupon rate

years to maturity

seniority

senior vs. subordinated

security

secured vs. unsecured

bond ratings measures

the issuer’s default risk

bond rating and default risk

the likelihood that the issuer does NOT repay the debt

grade and ratings

Aaa/AAA - investment

Aa/AA - investment

A - investment

Baa/BBB - investment

Ba/BB - non-investment

B - non-investment

Caa/CCC - non-investment

Ca/CC - non-investment
C - non-investment

D - non-investment

government bonds

treasury securities

municipal securities (or “munis”)

treasury securities

bonds issued by the federal government

treasury securities (T’s)

T-bills

T-notes

T-bonds

T-bills

mature in one year or less

T-notes

mature between 1 and 10 years

T-bonds

mature in more than 10 years

municipal securities (or “munis”)

• bonds issued by state and local government

• interest received is tax-exempt at the federal level.