READING 2 THE TIME VALUE OF MONEY IN FINANCE

Question 1

The investor pays less than the face value to buy the instrument and receives the face value at maturity.

Answer 1

One of the simplest examples of the time value of money concept is a pure discount debt instrument, such as a zero-coupon bond.

The price the investor pays depends on the instrument’s yield to maturity (the discount rate applied to the face value) and the time until maturity. The amount of interest the investor earns is the difference between the face value and the purchase price.

Question 2

True or false

In some circumstances, interest rates can be negative. A zero-coupon bond with a negative yield would be priced at a premium, which means its price is greater than its face value.

Answer 2

True

Question 3

The investor receives a cash interest payment each period in addition to the face value at maturity.

Answer 3

Fixed-coupon bond

The bond’s coupon rate is a percentage of the face value and determines the amount of the interest payments.

Question 4

Bonds that have no maturity date.

Answer 4

Perpetual bonds or perpetuities.

Question 5

A bond that pays a level amount each period, including its maturity period.

Answer 5

Amortizing bond

The difference between an amortizing bond and a fixed-coupon bond is that for an amortizing bond, each payment includes some portion of the principal.

With a fixed-coupon bond, the entire principal is paid to the investor on the maturity date.

Question 6

True or false

Amortizing bonds are an example of an annuity instrument.

Answer 6

True

Question 7

As with fixed-income securities, we value equity securities such as common and preferred stock as the present value of their future cash flows. The key differences are?

Answer 7

They don’t mature, and their cash flows may change over time.

Question 8

Pays a fixed dividend that is stated as a percentage of its par value (similar to the face value of a bond).

1. Preferred stock
2. Common stock

Answer 8

1. Preferred stock

As with bonds, we must distinguish between the stated percentage that determines the cash flows and the discount rate we apply to the cash flows.

We say that equity investors have a required return that will induce them to own an equity share. This required return is the discount rate we use to value equity securities.

Question 9

A residual claim to a company’s assets after it satisfies all other claims.

1. Preferred stock
2. Common stock

Answer 9

2. Common stock

Common stock typically does not promise a fixed dividend payment. Instead, the company’s management decides whether and when to pay common dividends.

Question 10

Assume a constant future dividend. Under this assumption, we can value