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UT Knoxville FINC 300 - Exam 2 Study Guide
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FINC 300 1st EditionExam # 2 Study Guide Lectures: 5 - 8Lecture 8 (Feb. 5)Ch. 5: Interest RatesInterest Rates are the prices of either receiving money or paying out money over time. Every basic finance or economics text refers to “the interest rate”. The effect of the term structure on the benefit-cost analysis and the Valuation Principle are examined, and the chapter concludes by answering the question, “which interest rate is appropriate?” for investment decisions. Nominal Rates Vs. Effective Rates- Periodic Rate- Effective Annual Rate- Interest Rates- Inflation- Yield CurvesNominal Rates (APR) versus Effective Rates (EAR) So far: We have often used Annual Percentage Rates (APR or nominal rates) when solving problems:�=�����������= ���=������������∗��������������������������Periodic Rate = ���/�where m is the number of compounding periods APRs (nominal rates) do NOT include the effect of compounding. So far, we have let our calculators compute the compound interest for us. We will continue to do this but what if we want to know the interest rate that includes the effects of compounding?The Effective Annual Rate (EAR) includes the effects of compounding and the total interest earned. EAR = APY (Annual Percentage Yield) = EFF Therefore, the EAR is often greater than the APR.���≥ R�����=〖(1+���/�)〗^�−1where m is the number of compounding periodsNote: This is an annual rate! This is not to be confused with the periodic rate we use when solving problems with monthly payments.Real Interest Rates Thus far, we have ignored the effect of inflation. When we ignore inflation, interest rates don’t represent the true increase in purchasing power. The real interest rate is the rate of growth of purchasing power after adjusting for inflation. The real rate is approximately equivalent to:nominal rate – rate of inflation More precisely:��������= (����������� −���������������)/((1 + ���������������)) Note: If the nominal rate is not greater than the rate of inflation, purchasing power doesn’t increase. Inflation Risks associated with:- Default- Liquidity- Taxes- Maturity (length of time)Yield Curves The yield curve is a plot of Treasury bond yields (considered to be risk-free) as a function of maturity terms:- Yield curves are normally upward sloping. - Long-term rates are normally higher in order to attract investors when rates are expected to rise and to compensate them for being “locked-in” for a longer period of time. - Because interest rates tend to drop in response to a slowdown in the economy, an inverted curve is often interpreted as a negative forecast for economic growth.Lecture 9(Feb 12) Ch. 5 Cont’d- Opportunity Cost of Capital- Amortized Loans- Balance Due without Table- OverpayOpportunity cost of capitalA. The opportunity cost of capital is what must be offered to investors if they are going to give up the opportunity to invest their funds elsewhere.B. It is the return the investor forgoes on an alternative investment of equivalent risk and term when the investor takes on a new investment.Amortized loansA. An amortized loan is a loan in which the borrower makes payments that include interest on the loan plus some part of the loan balance in order to pay off the loan over its life.B. First, the payment is calculated so that the same amount is paid each period (as we have done).C. Each payment is broken into interest and principal. Interest is calculated based on the rate times the balance owed. D. The remaining payment is applied towards principal owed.How can we determine how much we owe (the balance due) at any given time without making an amortization table?A. The remaining balance of any loan must be equal to the present value of the remaining payments.B. The remaining balance is the “worth” of the loan.C. We know the worth of any asset of the present value of its future cash flows.What happens when you pay more than required?A. The principal is reduced faster B. You pay less interest in the long run and therefore, a smaller total amount paid to the lenderC. Of course, the total principal repaid remains unchanged. Lecture 10 (Feb 12)Ch. 6- BondsThis chapter introduces an important part of the capital structure for most firms: bonds. It details the size and depth of the bond market and the types of bonds that are traded in this market. Most bonds are either zero-coupon or coupon bonds, and the characteristics of both bonds types are compared. Using the bond’s yield to maturity (the rate that equates the presentvalue of the bonds with the current market price), the impact of interest rates on bond prices and cash flows from the bonds are explained using both types of bonds. Throughout chapter 6, the theory presented will be ties to the very real-world recession of 2008. The chapter concludes with an analysis of how the risk of default crates credit spreads among the various rated bonds and the reaction of investors to these spreads. - Bonds- Federal Government Bonds- Yield to Maturity (YTM)What are bonds?Bonds are simply loans to a corporation or government entity. A. Note that bonds are not amortized loans. The principal, face value or par value of the bond, is not paid back until the final repayment date, the maturity date. The time remaining until the maturity date is called the term of the bond. However, many bonds do pay regular periodic interest payments called coupon payments.B. Zero coupon bonds are bonds that do not pay coupon payments and only pay the face value at maturity.Federal Government BondsA. Zero-Coupon Bonds: Treasury Bills: Mature within 1 yearB. Coupon Bonds:Treasury Notes: Mature within 1 to 10 yearsC. Treasury Bonds: Maturities greater than 10 years The Coupon Rate is the APR used to determine each coupon payment of the bond. Coupon Payment = (����������∗���������)/(����������������������) A. If a bond’s YTM = Coupon Rate, the bond price is equal to its face value. The bond is saidto sell at par.B. If a bond’s YTM > Coupon Rate, the bond price is less than its face value. The bond is said to sell at a discount.C. This means the bond is paying less interest than justified


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UT Knoxville FINC 300 - Exam 2 Study Guide

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