Topic 5 - Time Value of Money and Valuation of Bonds

Question 1

Explain the relationship that exists between bonds and market interest rates and interpret how this might affect bond investors

Answer 1

There is an inverse relationship. As interest rates decrease (YTM) bond prices increase. Therefore, those anticipating a market increase in interest rates will sell bonds. Conversely, those expecting a decrease will buy bonds.

Question 2

What is compound interest?

Answer 2

Compound interest is where interest paid on an investment during the first period is added
to the principal (the initial amount invested), and during the second period interest is earned on the original principal plus the interest earned during the first period
Therefore, money invested at compound interest accumulates at an increasing rate each period, exhibiting ‘exponential behaviour’

Question 3

What is the present value?

Answer 3

The current value of a sum of money representing a future payment that is discounted at an appropriate interest rate to reflect the time value of money.

Question 4

What is future value?

Answer 4

What a cash flow will be worth in the future

Question 5

What is simple interest?

Answer 5

The interest earned on the principle

Question 6

What is an APR?

Answer 6

An APR is an annual percentage rate. The interest earned in one year without compounding. It is the interest rate within a period multiplied by the number of periods in a year. APR = interest rate per period x compound periods per year.

Question 7

What is an EAR?

Answer 7

Effective annual rate. The annual compounded rate that produces the same return as the nominal or stated rate.

Question 8

What is an annuity?

Answer 8

A series of equal dollar payments that are
made at the end of equidistant points in time, such as monthly, quarterly or annually, over a finite period of time, such as three years. There are ordinary annuities and annuities due.

Question 9

What are ordinary annuities?

Answer 9

Those annuities for which payments occur at the end of the period.

Question 10

What are annuities due?

Answer 10

Those annuities for which payments occur at the beginning of the period, eg rent.

Question 11

What is a perpetuity?

Answer 11

An annuity which continues forever is called a perpetuity and these, by definition, do not have a future value.

Question 12

What is a bond?

Answer 12

A bond is a long-term debt security which pays the owner of the security a predetermined
amount of interest each year (coupons) and a principal amount (par value) at maturity.

Question 13

What elements determine a bond?

Answer 13

The investor’s required rate of return
The maturity date of the bond
The amount and timing of the bond cash flows which comprise periodic coupon amounts and the par value at the maturity date.

Question 14

What determines the valuation of a bond?

Answer 14

The bond value is calculated as the present value of the coupons plus the present value of the par value, discounted by the yield to maturity.

Question 15

What are ordinary shares?

Answer 15

Ordinary shares represent equity or ownership of a company

Question 16

What is a preference share?

Answer 16

A hybrid security that shares some of the features of bonds and ordinary shares:
they are a form of equity
They have no fixed maturity
Investors are paid a fixed dividend
They can be cumulative/non-cumulative
They can be redeemable/irredeemable.

Question 17

What is ERR for a bond called?

Answer 17

Yield to maturity

Question 18

How do you calculate ERR on preference shares?

Answer 18

The calculation of expected rates of return (ERR) is straightforward for preference shares,
where ERR=dividend yield = dividend/market value

Question 19

What are three uses for the time value of money in making business decisions?

Answer 19

Selecting an investment (deciding which is most profitable)
Deciding whether an investment should proceed (does it provide a return give TVM)
Evaluating the cost of borrowing, e.g the cost of converting current liabilities to long term liabilities.

Question 20

What are examples of annuities?

Answer 20

Mortgage payments, insurance payments, structured savings plans, pension payments.