I would rather receive proceeds from an investment paying 5% compound interest. The compound interest will be higher than the simple interest because the compound interest accrues on the principal amount plus accumulated interests of the previous periods. On the other hand, simple interest only accrues on the principal amount.
The future value interest factor for 10% 2 years is greater than the present value interest factor. This is because future value involves compounding while the present value involves discounting.
When the interest rate increases, the present value of annuity decreases but the future value of an annuity increases.
I would prefer a savings account paying interest compounded daily. The more frequent the compounding, the more interest the account earns. Daily compounding credits more interest to the account hence the interest received start earning interest sooner than in the case of annual compounding.
Annuity due is a contract where the first payment is made at time t = 0 rather than at the end of the first period. Examples include leases. Most lease contracts require initial payment at the beginning of the period.
More frequent compounding increases the present value since the interest received immediately starts earning interest on itself.
a) A marketing manager needs to understand the concept of present value since it is used in the determination of the Return on Marketing Investment (ROMI). ROMI is used by a marketing manager to justify a marketing program to the company’s executives as well as the finance department.
b) A personal manager needs to understand the present value concept since he/she advises the client on financial matters. For instance, a personal manager must be able to evaluate the financial implications of different offers available to the client and advise on the best alternative. This evaluation involves determining the present values.
Rule of 72 is a shortcut used to determine the number of years required to double an amount at a given rate of return. It is determined by dividing 72 by the annual compound interest rate.
Ordinary annuity involves payments made at the end of each period. An example of an ordinary annuity is the interest payments made to bond holders. An annuity due involves payments made in advance, that is, at the beginning of each period. An example is lease contracts.
a) If the required rate of return increases, the present value of an annuity decreases.
b) The future of an annuity will increase if the required rate of return increases.
ST1
Principal = $1,000
Rate = 8%
n = 5 years
when compounded annually
Future value = 1,000 ×1.085
= 1,000 ×1.469
= $1,469
compounding quarterly
n = 5 years × 4 = 20
Rate = 8%/4 = 2%
Future Value = 1,000 × 1.0220
= 1,000 × 1.486
= $1,486
ST 2
Annuity = $1,000
r = 12% and n = 10 years
Present value of the annuity = Annuity × PVIFA12%, 10 years
= 1,000 × 5.650
= $5,650
Question 1
Indenture is a contract between the bond issuer and the bond holder. It specifies the terms of the bond agreement.
A trustee is a person who administer a property or assets on behalf of and for the benefit of a third party.
Call feature is a feature of an indenture that allows the issuer of a bond to buy it back at a specified price within a specified period of time.
A sinking fund is a fund which a firm sets by periodically setting aside money for repaying debt or replacing a depreciable asset.
Conversion feature allows the bondholder to exchange the bond for a given amount of the issuer’s equity.
Coupon rate is the rate of interest paid regularly to bond holders based on the par value of the bond.
Question 2
Mortgage bonds: Mortgage bonds are backed by a pool of home mortgages. Besides, they are pass-through securities and have a high liquidity.
Debenture: Debenture holders are creditors to the company and not owners. A debenture has a fixed term after which they must be redeemed by the company. The return on debentures is predetermined and is paid in the form of interest. Debenture holders do not have voting rights. Furthermore, interest on debentures is charged against profit is an allowable expense for taxation purposes.
Subordinated debentures: They are unsecured debentures and have a subordinated agreement that makes them subordinate to other bonds in the event of liquidation of the issuing company.
Equipment Trust Certificate: An instrument that allows a firm to take an asset and pay for it over time. The debt is secured on asset or equipment that is held in trust for all the bondholders. When the issuer repays the debt, the equipment becomes the property of the company.
Collateral Trust Bonds: These are bonds secured on securities such as equity and bonds rather than real property. Common with companies with little or no real property but many securities.
Income bonds: The interest on these bonds is not predetermined but depends on the earnings of the company. Coupon interest is paid to the holder only if the company has adequate earnings. The holder is only guaranteed of the principal.
Question 3
