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Exam 2 business finance
Terms in this set (46)
1. All other things equal, how would the following changes impact the PV?
a. Decrease in FV
i. If future value decreases, present value will also decrease.
a. Increase in interest rate
i. An increase of the interest rate will decrease the present value
b. Decrease in number of time periods
i. A decrease in the number of time periods will make the presect value higher.
1. Why does an annuity due always have a higher future value than an ordinary annuity?
This is because you start receiving your payments earlier
1. What is the difference between simple interest and compound interest?
Simple interest is interest earned on a set rate. If I put in $100 at a 10% interest rate then I would get $10 every year of investing.
Compound interest gives a return on your investment at an accelerated rate. You can earn interest on your interest. If you put in $100 at 10% you would make $10 the first year and $11 the second year. This would continue on for the future years. FV=PV(1+i)^n
APR: Nominal Interest Rate:
This is the quoted or stated rate. If a bank were to say that a rate was 10% annually, then the actual value of the rate would remain the 10% because it will be paid at the end of the year.
Scenario: If I were to buy a car for $32000 with a nominal interest rate of 10%, then the interest that I would pay on the car would be $3200 annually.
1+[(NOM/n)]^n +1A 10% annual rate that is paid semiannually would actually be 10.25% because it is paid earlier in the time period.
Scenario: If I were to buy a car for $32000 with an annual interest rate of 10% paid semiannually, I would pay $1600 the first payment (32000
.05) and 1680 on the second payment [(32000+1600)
.05]. In total, I would pay $35280 instead of $35200. This would mean that I would pay $80 more for the first year of payments on the car. This would continue to get higher as time goes on.
1. What role do interest rates play in allocating capital to different potential borrowers?
If interest rates are projected to change in the future, it can make a major difference on borrower's decisions on how much to borrow for a certain time period.
For example, if I were to need to borrow $10,000, I may not want to borrow it all at once. If the I think the interest rate will go down by 1% in the next year and I only need to have $1000 this year, then I should borrow the $1000 this year at the higher rate and wait to borrow the other $9000 after the interest rate drops 1%.
1. How does the price of capital tend to change during a boom? During a recession?
During a boom the value of capital increases. (interest rates and the value of capital is higher because people think that the value of their assets goes up)
During a rescission the value of capital decreases.
1. Identify some macroeconomic factors that influence interest rates and explain the effects of each.
Federal Reserve policy·
The federal budget deficit or surplus
o foreign trade balance
o interest rates in other countries
Level of business activity
International factors :foreign trade balance
§ You could run a foreign trade deficit if you buy more foreign goods than you sell. This would increase interest rates because the country would have to borrow money to purchase the excess goods.
International factors: interest rates in other countries
§ If interest rates in other countries are higher, then more people are likely to borrow money from America. This would make interest rates highly dependent on what the rates are in the rest of the world because the rate can change based on those of other countries.
· Federal Reserve policy
o In the U.S., the fed has major control over money supply. It is very clear that money supply has major impacts on interest rates as well as economic activity and inflation.
· Federal budget deficit or surplus
o In essence, if the government is in need of money they can borrow it which increases interest rates.
· Level of business activity
o Interest rates change based on the level of business activity. As stated above, if the economy is booming and there is a lot of economic activity, then interest rates will be higher. If there is a recession, the interest rates will decrease with a decrease in business activity and an decrease in inflation.
Interest rate risk
is the risk of a bonds price going down due to an increase in interest rates.
different from interest rate risk because it is short term. There is a risk that the interest rate will change and cause the bond to have a lower value than it originally would have had. A short-term bond with a high coupon rate will have low price risk but considerable reinvestment risk.
Holders of long-term bonds are more concerned about of Interest rate risk. They are looking for long term stability in a bond's price. A slight interest rate fluctuation over time is not a problem as long as the overall interest rate increases over time.
Holders of short-term bonds are more concerned about reinvestment risk. They do not want a bond to lose value all of the sudden when it matures.
Value of any financial asset
The present value of all future cash flows
If interest rates go up, value of bond goes down
If interest rates go down, value of bond goes down
Interest rate risk
A change in interest rates implies a change in the value of assets.
If interest rates go up then the value of the asset will go down
If interest rates go down the value of the asset can go up
Reinvestment Rate Risk
uncertainty surrounding the cumulative future value of reinvested bond coupon payments
Secondary bond market
You can sell a bond before it matures
The money received during the maturity of the bond
The money you will receive = 15m in example
Coupon rate*Par value
Determined at the time the bond is issued
Par value (face value)
The amount that must be repaid at maturity (10M in example)
Unless stated otherwise, in this class par value is $1000
The borrower (The one who issues bonds for money)
Makes money at interest
Money back is referred to as
Yield or Return
When solving for YTM you are solving for I
Return that you get because you get an interest payment
Can be negative too
Return on stock
Solving for present value
CGY is a % change in price
(New Price-Old price)/Old price
If savings go down
supply goes down.
If supply goes down
interest rates go up.
Demand is driven by the
Savings rate seems to go up during a
The real risk free rate
A baseline rate that would be on an investment with no risk at all
Short term treasury bill
The amount of people who are in the market to buy a bond
Maturity Risk Premium
If the maturity is longer, you will have to pay a higher rate to borrow the money
Default Risk Premium
A premium that is charged if you are more likely to default on a debt
Upward sloping yield curve=
Normal yield curve
Borrow long term
what determines the shape of the yield curve
An inverted yield curve is a very good indicator of a coming recession
About a year out
a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year
This insures that the bond can be redeemed within the call period because the company must have funds to redeem the bond on hand.
allows issuer to to redeem bond issue before its maturity date. either in whole or in partial.
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