Assignment Week 2 FIN307

**Chapter 4 Questions**

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Assignment Week 2 FIN307

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**Define each of the following terms:**

- PV; I; INT; FVN; PVAN; FVAN; PMT; M; INOM
- 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

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

**Chapter 5**

**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, r ; nominal risk-free rate of interest, rRF
- Inflationpremium (IP);defaultriskpremium(DRP);liquidity;liquiditypremium(LP)
- Interest rate risk; maturity risk premium (MRP); reinvestment rate risk
- Term structure of interest rates; yield curve n. “Normal” yield curve; inverted (“abnormal”) yield curve

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.

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Week 2 Assignment-FIN307

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CHAPTER 4 QUESTIONS

**Define each of the following terms:**

**a.PV; I; INT; FVN; PVAN; FVAN; PMT; M; INOM **

PV- This is a financial abbreviation that represents the present value (current value) of money or an asset that would be received in future.

(I) is a financial acronym which stands for investment.

INT- Is a financial abbreviation that stands for interest rate

FVN- Is an acronym which means the Future Value of money or an asset in a specific number of years.

PVAN- This is a financial acronym which stands for the Present or current value of the annuity is a specific number of years represented by the letter (N) (Pandey, 1995)

FVAN- It is an abbreviation which stands for the future value of an annuity in a certain number of year.

PMT- Refers to the payments made or received in the form of annuities (annuity payments).

M- It is a symbol for 1,000. It is also used to show that a bond has matured or dividend on the certain stock has been decreased by a specific amount.

INOM- the Interest rate on interest on invested money.

**Opportunity cost rate**

This is the rate of return that an investor could earn an investment opportunity foregone.

**Annuity; lump-sum payment; cash flow; uneven cash flow stream**

An* annuity* is a fixed amount that is paid to someone on yearly basis.

*A lump-sum payment* refers to a single payment of a certain sum of money as opposed to continuous payment (Pandey, 1995).

*Uneven cash flow stream*: refers to a series of payment that is not uniform or does not conform to the description of an annuity (Pandey, 1995).

**Ordinary (or deferred) annuity; annuity due payment of**

*Ordinary annuity*: This refers to a sequence of equal payments which are made at the close of every year for a specific period.

*Annuity due payment – *This is an annuity whose disbursements are made at the beginning of every year.

**Perpetuity; consol**

*Perpetuity* can be described as an annuity whose periodic payments start at a certain date and go on indefinitely.

*Consol *– This is a type of bond that has no maturity date. It is a debt instrument without the planned return of the principal, hence perpetual interest payment with no maturity.

**Outflow; inflow; timeline; terminal value**

In finance, outflow is a term used to refer to the amount of cash that the capital or cash paid out by an organization while inflows mean the money that an organization receives from various sources. Inflows include profit and returns earned while outflows include expenses (Pandey, 1995).

*Timeline*– This is a chart or a line that shows a firm’s cash outflows and cash inflows as well as the business activities behind them over a certain period of time.

**Compounding; discounting**

*Compounding: *It is a mathematical process that entails the growth of the value of an asset or an investment due to the interest earned on the accumulated interest as well as the principle over a given period (Pandey, 1995). It involves finding the future value of an investment or an asset certain period using a given interest rate.

*Discounting: *It is a process the entails finding the current value of an asset, stream of cash flow or a sum of money within a period using specified interest rate.

**Annual, semiannual, quarterly, monthly, and daily compounding**

*Annual compounding*-involves calculating future value of money on a yearly basis where n=1

*Semiannual compounding*-entails calculating future of money on a six-month basis where n=2

*Quarterly compounding*-involves finding the future value of three-month basis where n=4 (Pandey, 1995)

*Monthly compounding* – Involves calculating the future value on a monthly basis where n=12

*Daily compounding*– entails finding future value on a day to day basis where n=365

**Effective annual rate (EAR or EFF%); nominal (quoted) interest rate; APR; periodic rate**

EAR is the interest rate that has been adjusted for compounding for a given period. It is the interest rate that is actually paid or earned on loan or investment (Pandey, 1995). On the other hand, Nominal interest rate is the interest rate that has not been adjusted for inflation or any fees.

(APR) can be described as yearly rate charged on money earned or borrowed capital.

The periodic rate is the rate charged on loan over a certain period.

**Amortization schedule; principal versus interest component of a payment; amortized loan**

An amortization schedule is a table that shows detailed payments over a specific period. The schedule shows the amount paid as interest and to principle including the initial amount.

The principles are the amount borrowed or the money that ought to be paid back while interest is the amount paid by a borrower along with the principal as the cost of borrowing (Pandey, 1995).

Amortized loan is a kind of loan that is coupled with a planned periodic payment composed of both the interest and the principle.

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

I would rather have a savings account that pays 5% interest that is compounded daily since I will have higher savings at the end of the period.

CHAPTER 5 QUESTIONS

**Define each of the following terms: **

**Bond; Treasury bond; corporate bond; municipal bond; foreign bond**

*A bond* is security where the issuer owes a holder a debt (Baur and Lucey, 2010).

*Treasury bonds* are interest-bearing securities issued by the government.

*Corporate bond* refers to debt security issued by a company and sold to stockholders (Kim et al., 1993).

*Municipal bond: *It is a type of bond that is issued by the local authority. * *

*Foreign bond:* Is issued in the domestic market by a foreign organization (Baur and Lucey, 2010).

**Par value; maturity date; coupon payment; coupon interest rate**

*Par value: *is the face value of a bond (Baur and Lucey, 2010).

*Maturity date:* It is the final date for paying a debt instrument or loan, a time when all outstanding interest and principle ought to be paid.

*Coupon interest rate: *Is the interest rate paid by those who issue bonds on the face value of the instrument (Kim et al., 1993).

- c
**. Floating-rate bond; zero coupon bond; original issue discount bond (OID)**

A floating rate bond is a bond with changing interest rate depending on changes that take place in the market.

A Coupon bond is one which is sold at a discount with no interest payment (Baur and Lucey, 2010).

Original issues discount bond is the price cut from the face value of a bond at a time when it is issued.

**Call provision; redeemable bond; sinking fund**

A call provision can be defined as a clause on a fixed-instrument which permits the original issuer to retire or repurchase the bond.

Redeemable bonds are those that can be redeemed by the issuer before their maturity date

Sinking fund- Means a savings account whose deposits are set aside for debt repayment.

**Convertible bond; warrant; income bond; indexed bond (also called a purchasing power bond)**

A convertible bond is one which can be transformed by the issuing company into shares or stocks

A warrant is a security that permits the holder to purchase the underlying shares of the issuing firm at a fixed amount known as exercise price until specific expiry date (Baur and Lucey, 2010)

An income bond is a bond that pays interest based on the profit earned by the user company.

Indexed bond is a type of bond whose interest rate is linked to a certain index such that they can rise or fall due to changes in the rate of inflation (Baur and Lucey, 2010).

**Premium bond; discount bond**

A premium bond is one which trades above its par value while a discount bond trades below its face value.

**Current yield (on a bond); yield to maturity (YTM); yield to call (YTC)**

It is the annual rate of return that investors can expect. It is the annual interest payment divided by the existing bond price.

Yield to maturity refers to the total returns that are expected on a bond if it is held until when it matures.

Yield to call is the projected returns an investor would receive in case the bond is called by the seller prior to its maturity (Baur and Lucey, 2010).

**Indentures; mortgage bond; debenture; subordinated debenture**

An indenture is a legal agreement between bond issuers and bondholders.

A mortgage bond is a bond that is backed by a pool of mortgages.

A debenture is a security issued by an organization that is not backed or secured by collateral.

A subordinated debenture is one that ranks after other debts in case a firm falls into bankruptcy.

**Development bond; municipal bond insurance; junk bond; investment-grade bond**

A bond issued so as to raise money to accomplish a development project. It is often issued by the government (Kim et al., 1993).

Municipal bond insurance is an insurance cover on bond, underwritten by a private insurance firm.

A junk bond can be defined as high-risk security issued by an organization that seeks to raise money quickly to finance a takeover (Baur and Lucey, 2010).

Investment-grade bond- A bond rated BBB

**The real risk-free rate of interest, r ; nomina risk-free rate of interest, Rrf**

The real risk-free rate of interest- An adjusted (takes into account inflation) rate of return for an investment with no risk.

The nominal risk-free rate of interest- Is the interest rate before considering inflation.

**Inflation premium (IP);default risk premium(DRP);liquidity; liquidity premium(LP)**

Inflation premium is the return on investment above its nominal rate of return.

- Interest rate risk; maturity risk premium (MRP); reinvestment rate risk

The default risk premium is the difference between the risk-free rate and the interest rate of a debt instrument (Kim et al., 1993).

Liquidity-describes how quickly security can be transformed into cash.

Liquidity premium is compensation to investors having securities that cannot be easily converted to cash.

**Term structure of interest rates; yield curve n. “Normal” yield curve; inverted (“abnormal”) yield curve**

Term structure of interest rates is the relationship between bond yields and various term maturities.

A yield curve is a line or graph that shows different yield at respective maturity dates.

“Normal” yield curve- is a yield curve where long-term debt instrument has a higher yield than short-term instruments with similar credit quality (Kim et al., 1993).

Inverted (“abnormal”) yield curve. – Happens when yields on short term bonds are higher than yields for long term bonds.

**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.**

**Advantages**

Bondholders with sinking fund are safer than who do not have it.

Bond issuers can maintain the cost of the fund since they are purchased from an open market (Kwan, and Carleton, 2010)

With a sinking fund, bonds are retired in an orderly manner.

**Disadvantages **

In case of an increase in interest rate issuers will redeem a minimum share of a bond and sell the new bond at a higher rate thus increasing the cost of debt (Kwan and Carleton, 2010).

A bond with sinking funds has a lower coupon rate than one without a sinking fund.

If the issuers retire part if the face value every year, they lose the chance of investing the money in return yield securities.

REFERENCES

Baur, D. G., & Lucey, B. M. (2010). Is gold a hedge or a safe haven? An analysis of stocks, bonds and gold. *Financial Review*, *45*(2), 217-229.

Kim, I. J., Ramaswamy, K., & Sundaresan, S. (1993). Does default risk in coupons affect the valuation of corporate bonds?: A contingent claims model. *Financial Management*, 117- 131.

Kwan, S. H., & Carleton, W. T. (2010). Financial contracting and the choice between private placement and publicly offered bonds. *Journal of Money, Credit and Banking*, *42*(5), 907-929.

Pandey, I. M. (1995). *Essentials of Financial Management, 4th Edtion*. Vikas Publishing House.

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