FIN Chapter 5,6,7 Connect Questions

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Assume the total cost of a college education will be $200,000 when your child enters college in 16 years. You presently have $61,000 to invest.

What annual rate of interest must you earn on your investment to cover the cost of your child's college education?

7.70 %

At 7.20 percent interest, how long does it take to double your money?


At 7.20 percent interest, how long does it take to quadruple it?

9.97 Years
19.94 years

Assume that in January 2010, the average house price in a particular area was $280,400. In January 2001, the average price was $197,300.

What was the annual increase in selling price?

3.98 %

You are investing $100 today in a savings account at your local bank. Which one of the following terms refers to the value of this investment one year from now?

future value

Tracy invested $1,000 five years ago and earns 4 percent interest on her investment. By leaving her interest earnings in her account, she increases the amount of interest she earns each year. The way she is handling her interest income is referred to as which one of the following?

compounding

Sara invested $500 six years ago at 5 percent interest. She spends her earnings as soon as she earns any interest so she only receives interest on her initial $500 investment. Which type of interest is Sara earning?

simple interest

Samantha opened a savings account this morning. Her money will earn 5 percent interest, compounded annually. After five years, her savings account will be worth $5,600. Assume she will not make any withdrawals. Given this, which one of the following statements is true?

Samantha could have deposited less money and still had $5,600 in five years if she could have earned 5.5 percent interest.

Which one of the following variables is the exponent in the present value formula?

Time

You want to have $1 million in your savings account when you retire. You plan on investing a single lump sum today to fund this goal. You are planning on investing in an account which will pay 7.5 percent annual interest. Which of the following will reduce the amount that you must deposit today if you are to have your desired $1 million on the day you retire?

I. Invest in a different account paying a higher rate of interest.
II. Invest in a different account paying a lower rate of interest.
III. Retire later.
IV. Retire sooner.

I and III only

One of your customers is delinquent on his accounts payable balance. You've mutually agreed to a repayment schedule of $500 per month. You will charge 1.95 percent per month interest on the overdue balance.

If the current balance is $18,500, how long will it take for the account to be paid off?

66.19 %

Friendly's Quick Loans, Inc., offers you "three for four or 1 knock on your door." This means you get $3.30 today and repay $4.30 when you get your paycheck in one week (or else).

If you were brave enough to ask, what APR would Friendly's say you were paying?

What's the effective annual return Friendly's earns on this lending business?

1,575,76 %
94979331.00 %

Live Forever Life Insurance Co. is selling a perpetuity contract that pays $1,850 monthly. The contract currently sells for $122,000.

What is the monthly return on this investment vehicle?

Monthly Return

APR

Effective annual return

1.52 % per month

18.20 %

19.79 %

The Maybe Pay Life Insurance Co. is trying to sell you an investment policy that will pay you and your heirs $29,000 per year forever. Suppose a sales associate told you the policy costs $474,000. At what interest rate would this be a fair deal?

Interest rate 6.12 %

Theresa adds $1,500 to her savings account on the first day of each year. Marcus adds $1,500 to his savings account on the last day of each year. They both earn 6.5 percent annual interest. What is the difference in their savings account balances at the end of 35 years?

$12,093

Which of the following statements related to interest rates are correct?

I. Annual interest rates consider the effect of interest earned on reinvested interest payments.
II. When comparing loans, you should compare the effective annual rates.
III. Lenders are required by law to disclose the effective annual rate of a loan to prospective borrowers.
IV. Annual and effective interest rates are equal when interest is compounded annually.

II and IV only

Which one of the following statements concerning interest rates is correct?

The effective annual rate equals the annual percentage rate when interest is compounded annually.

Which one of these statements related to growing annuities and perpetuities is correct?

The present value of a growing perpetuity will decrease if the discount rate is increased.

Which one of the following compounding periods will yield the smallest present value given a stated future value and annual percentage rate?

continuous

What are the main differences between debt and equity bonds?

1. Debt is not an ownership interest in the firm. Creditors do not generally have voting power.
2. The corporation paying interest out on debt is considered a cost expense and so it is tax deductible. Dividends paid to stock holders are NOT tax deductible.
3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

Who has the final say on declaring the type of a security?

Courts and taxing authorities have the final say

Why do corporations generally like to create hybrids of equity and debt securities?

To reap the benefits of each type.
"One reason is that corps try to create a debt security that is really equity to obtain the tax benefits of a debt security and the bankruptcy benefits of an equity security.

What type of term is 'unfunded debt' considered?

Short-term debt

What type of security is a bond?

a secured debt

What is the difference between a note and a bond?

the original maturity. Issues with an original maturity of 10 years or less are often called notes. Longer-term issues are called bonds.

What is an indenture?

an indenture is the written agreement between the corporation ( borrower ) and its creditor sometimes referred to as the 'deed of trust'.

What is a trustee and what does it do?

a trustee ( a bank, perhaps ) is appointed by the borrowing corporation to represent the bondholders. The trust company must
1. Make sure the terms of the indenture are obeyed
2. manage the sinking funds
3. Represent the bondholders in default - that is, if the company defaults on its payments to them.

What are the 6 provisions in an indenture?

1. The basic terms of the bonds
2. the total amount of the bonds issued
3. a description of property used as security
4. the repayment arrangements
5. the call provisions
6. Details of the protective covenants

What is 'registered form' ?

the form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record

what is 'bearer form'?

The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond

Between bearer bonds and registered bonds, which is more popular?

Registered bonds

How are Debt securities classified?

Debt securities are classified according to the collateral and mortgages used to protect the bondholder.

what is a blanket mortgage

a blanket mortgage pledges all the real property owned by the company.

what is a debenture?

a debenture is an unsecured bond, for which no specific pledge of property is made. Whatever is left over from mortgages and collateral is what is left to debentures.

What is a note?

a note is an unsecured bond with 10 years or less to maturity.

What is Seniority?

Seniority refers to which creditors will be paid first. Creditors with more seniority will be paid sooner than those with lower seniority. Creditors with lower seniority are called 'subordinated' creditors.

what is a sinking fund?

a sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds.

What is a Call Provision

a Call Provision allows a company to repurchase or 'call' part or all of the bond issue at stated prices over a specific period.

What is a Call Premium?

a Call Premium is the difference over the call price and the stated value.

What is a "Make-whole" provision?

This is when a company buys back its bonds for their approximate worth.

What is a deferred call provision?

A call provision prohibiting the company from redeeming a bond prior to a certain date.

What is a call-protected bond?

a bond that, during a certain period, cannot be redeemed by the issuer.

What is a protective Covenant?

A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest.

What are zero coupon bonds?

A bond that makes no coupon payments and is thus initially priced at a deep discount.

What are real rates?

Interest rates or rates of return that have been adjusted for inflation.

What are nominal rates?

Interest rates or rates of return that have NOT been adjusted for inflation.

What is the Fisher Effect?

The relationship between nominal returns, real returns, and inflation.

What is a term structure of interest rates?

The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money.

What is an inflation premium?

The portion of a nominal interest rate that represents compensation for expected future inflation.

What is an interest rate risk premium?

The compensation investors demand for bearing interest rate risk.

Treasury yield curve

A plot of the yields on Treasury notes and bonds relative to maturity.

Default risk premium

The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default.

Taxability premium

The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.

Liquidity premium

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.

What is a coupon?

The stated interest payment made on a bond.

What does face value mean?

The principal amount of a bond that is repaid at the end of the term. Also called par value.

coupon rate

The annual coupon divided by the face value of a bond.

maturity

The specified date on which the principal amount of a bond is paid.

yield to maturity

The market interest rate of a bond.

Ordinary Annuity

A series of constant or level cash flows that occur at the end of each period for some fixed number of periods is called an ordinary annuity.

Annuity Due

An annuity for which the cash flows occur at the beginning of the period.

Perpetuity

An annuity in which the cash flows continue forever.

Consol

Perpetuities are also called Consols, particularly in Canada and the UK.

Stated Interest Rate

The interest rate expressed in terms of the interest payment made each period.

Effective Annual Rate

The interest rate you will actually earn on a security.

APR - Annual Percentage Rate

The interest rate charged per period multiplied by the number of periods per year.

Pure Discount Loan

The pure discount loan is the simplest form of loan. The borrower receives money today and repays a single lump sum at some time in the future.

Interest-Only Loan

Where only interest payments are made every period and the principal is paid in full at maturity.

Amortized Loan

Where interest plus some of the principle are paid each period until the all principle has been repaid.

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