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What is an opportunity cost? How is this concept used in TVM analysis, and where is it shown on a time line? Is a single number used in all situations? Explain.

Explain whether the following statement is true or false: \$100 a year for 10 years is an annuity; but \$100 in Year 1, \$200 in Year 2, and \$400 in Years 3 through 10 does not constitute an annuity. However, the second series contains an annuity.

To find the present value of an uneven series of cash flows, you must find the PVs of the individual cash flows and then sum them. Annuity procedures can never be of use, even when some of the cash flows constitute an annuity because the entire series is not an annuity. True or false? Explain.

Banks and other lenders are required to disclose a rate called the APR. What is this rate? Why did Congress require that it be disclosed? Is it the same as the effective annual rate? If you were comparing the costs of loans from different lenders, could you use their APRs to determine the loan with the lowest effective interest rate? Explain.

Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a short-term basis? Why?

EXPECTED INTEREST RATE The real risk-free rate is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?

DEFAULT RISK PREMIUM The real risk-free rate, r*, is 2.5%. Inflation is expected to average 2.8% a year for the next 4 years, after which time inflation is expected to average 3.75% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 8.3%,

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Solution Summary

The solution explains some questions relating to time value of money, interest rates and risk premium

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What is an opportunity cost? How is this concept used in TVM analysis, and where is it shown on a time line? Is a single number used in all situations? Explain.
The opportunity cost is defined as the rate which we can earn on an alternative investment which has the same risk as the current investment. When we invest in an opportunity, we cannot invest in another opportunity, this loss is called the opportunity cost which is the rate which we could have earned on the lost investment opportunity.
In TVM, opportunity cost is the discounting rate used to discount the cash flows. It is shown above the time line in between the first and second tick marks
The opportunity cost represents the riskiness of the investment and so would change with investment and so will not be same. For a given investment also, the opportunity cost may vary from period to period depending on the inflation expectations since the return earned is the nominal return and so is affected by inflation.

Explain whether the following statement is true or false: \$100 a year for 10 years is an annuity; but \$100 in Year 1, \$200 in Year 2, and \$400 in Years 3 through 10 does not constitute an annuity. However, the second series contains an annuity.
The statement is true. \$100 in Year 1, \$200 in Year 2, and \$400 in Years 3 through ...

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