Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank's evaluation process, you have been asked to take an examination which covers several financial analysis techniques. The first section of the test addresses discounted cash flow analysis and bonds. See how you would do by answering the following questions.

1. The notion that money has "time-value" is based on the existence of a nonzero "opportunity rate", i.e., a rate of return at which it is possible to invest. Why is the opportunity rate so important?

2. Present value is used extensively by managers who are reviewing proposed projects. How does the present value of a cash flow assist management in making these business decisions?

3. Jackson Central has a 6-year, 8% annual coupon bond with a $1,000 par value. Earls Enterprises has a 12-year, 8% annual coupon bond with a $1,000 par value. Both bonds currently have a yield to maturity of 6%. If the market yield increases to 7%, which bond will you recommend to your client?

4. Assume the real rate of interest on 1-year, 10-year, and 30-year bonds is 3%. Also, assume the rate of inflation is expected to be 3% for the coming year. Considering only an inflation premium, construct an example showing how an expected increase in the rate of inflation leads to an upward-sloping term structure via the Fisher effect. Then, explain how the addition of interest rate risk will affect your results.