Managerial Finance - Exam 3

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.

$ 536.38 Calculator solution: Input N = 20, I/YR = 14, PMT = 70, and FV = 1000, and solve for VB = PV = $536.38.

Delta Corporation has a bond issue outstanding with a 7% coupon, semiannual payments, and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.

$ 791.00 Calculator solution: Input N = 8, I/YR = 7, PMT = 35, and FV = 1000, and solve for VB = PV = $791.00.

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.

$ 796.04 Calculator solution: Input N = 4, I/YR = 14, PMT = 70, and FV = 1000, and solve for VB = PV = $796.04.

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. Its' yield to maturity is 6.53%. Assume that the yield to maturity remains constant for the next two years. What will be the price of the bond two years from today?

$ 964.61 N = 4; I/YR = 6.5339; PMT = 55; FV = 1000; PV = ? Solve for VB = PV = $964.61.

Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 6.20%, based on semiannual compounding. What is the bond's price?

$1,101.58 Par value = FV $1000 Coupon rate 7.25% Periods/year 2 Yrs to maturity 15 Periods = years x 2 = N 30 Going annual rate = YTM = r(littleD) 6.20% Periodic rate = r(littleD)/2 = I/YR 3.10% Coupon rate x Par/2 = PMT $36.25 PV $1101.58

View each of the below-listed provisions that are often contained in bond indentures alone. Which of these provisions would tend to REDUCE the yield to maturity that investors would otherwise require on a newly issued bond? 1. Fixed assets are used as security for a bond. 2. A given bond is subordinated to other classes of debt. 3. The bond can be converted into the firm's common stock. 4. The bond has a sinking fund. 5. The bond has a call provision. 6. The indenture contains covenants that restrict the use of additional debt.

1, 3, 4, 6

Assume that the real risk-free rate, r*, is 4% and that inflation is expected to be 7% in Year 1, 4% in Year 2, and 3% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 11%, what is the difference in the maturity risk premiums (MRPs) on the two bonds; that is, what is MRP5 - MRP2?

1.5%

You have determined the following data for a given bond: Real risk-free rate (r*) = 3%; inflation premium = 8%; default risk premium = 2%; liquidity premium = 2%; and maturity risk premium = 1%. What is the nominal risk-free rate, rRF?

11%

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000 and present market conditions justify a 14% nominal annual required rate of return. What is the bond's current yield?

13.05% Input N = 20, I/YR = 14, PMT = 70, FV = 1000, and solve for V(little 5) = PV = $536.38 Next, Solve for the current yield: Current yield = Annual interest /Current price of bond =$70/$536.38 =13.05%

Acme Products has a bond issue outstanding with 8 years remaining to maturity, a coupon rate of 10% with interest paid annually, and a par value of $1,000. If the current market price of the bond issue is $814.45, what is the yield to maturity, rd?

14% Calculator solution: Input N = 8, PV = -814.45, PMT = 100, and FV = 1000, and solve for I/YR = rd = 14.00%.

A Treasury bond that matures in 20 years has a yield of 8%. A 20-year corporate bond has a yield of 11%. Assume that the liquidity premium on the corporate bond is 1.0%. What is the default risk premium on the corporate bond?

2.00%

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

2.00% Inflation = rT10 - r* - MRP

McCue Inc.'s bonds currently sell for $1,250. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM)

2.62%

If all interest rates in the economy fall by 1%, which of the following bonds would have the greatest percentage increase in value?

20-year, zero coupon bond.

Taussig Corp.'s bonds currently sell for $1,150. They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds?

4.20% Par value = $1000 Coupon = 6.35% N = 20 Price = PV $1150 PMT = Par x Coupon $63.50 FV = $1000 I/YR = YTM 5.13% If called: Par value = $1000 Coupon = 6.35% N = 5 PV = $1150 PMT = $63.50 FV = $1067.50 I/YR = YTC = 4.20% Expected rate of return = YTC if Coupon > YTM 6.35% > 5.13% Expected rate of return = YTC = 4.20%

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 3-year Treasury securities?

5.7% r* = 2%; I1 = 3%; I2 = 3%; I3 = 5%; I4 = 5%; I5 = 5%; MRP = 0; rT3 = ? Since these are Treasury securities, DRP = LP = 0. rT3 = r* + IP3. IP3 = (3% + 3% + 5%)/3 = 3.67%. rT3 = 2% + 3.67% = 5.67% ≈ 5.7%.

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's current yield?

5.79%

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 5-year Treasury securities?

6.2%

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?

6.20% Compounded return on series of 1-year bonds at above rate = (1.056)(1.056) = 1.115136 Compounded return on series of 1-year bonds = (1.05 )(1 + X) = 1.1151 Expected Yield on a 1-year bond 1 year from now. X in the equation: (1.05)(1 + X) =1.1151 X =1.1151/1.05 -1 = 6.20%

Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,120. What is the bond's nominal yield to call?

6.53% Coupon rate 8.25$ YTM 6.50% Maturity 15 Par value $1000 Periods/year 2 Determine the bond's price: PMT/period $41.25 N 30 I/YR 3.25% FV $1000.00 PV = Price $1166.09 Call price $1,120 Yrs to call 6 Coupon rate 8.25% YTM 6.50% Maturity 15 Par value $1000 Periods/year 2 Determine the bond's YTC: N 12 PV $1,166.09 (-1,16609) PMT $41.25 FV $1,120.00 1/YR 3.26% Nom. YTC 6.53%

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's yield to maturity, rd?

6.53% N = 6; PV = -950; PMT = 55; FV = 1000; YTM = ? Solve for I/YR = YTM = 6.5339% ≈ 6.53%.

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond?

6.812%

A bond that matures in 8 years has a 10% coupon rate, semiannual payments, a face value of $1,000, and an 8.5% current yield. What is the bond's nominal yield to maturity (YTM)?

7.1% N= 8x2 = 16; PMT - 0.10/2x1000 = 50; FV = 1000; V(little 5)=PV =?; YTM = ? Solve for V(littleB) = PV using the 8.5% current yield: Current yield = Annual interest payment/Current bond price 8.5% = $100/V(littleB) V(littleB) = $100/0.085 V(littleB) = $1176.47 N=16; PV = -1176.47; PMT = 50; FV = 1000; YTM = 7.1% Solve for I/YR = YTM = r(littleD)/2x2=3.5368%x2=7.0736%~~7.1%

Interest rates on 4-year Treasury securities are currently 6.5%, while 6-year Treasury securities yield 6.8%. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? Use the geometric average to arrive at your answer.

7.4%

Which of the following situations would be most likely to lead to an increase in interest rates in the economy?

Corporations step up their expansion plans and thus increase their demand for capital.

If interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 6.27% AAA = 9.72% BBB = 11.42% Then differences in these rates were probably caused primarily by:

Default and liquidity risk differences.

Interest rates on 20-year Treasury and corporate bonds with different ratings, all noncallable, are as follows: T-bond = 6.32% A = 8.46% AAA = 7.78% BBB = 9.28% The differences in rates among these issues were most probably caused by:

Default and liquidity risk differences.

Assume interest rates on 30-year government and corporate bonds were as follows: T-bond = 7.72%; AAA = 8.72%; A = 9.64%; BBB = 10.18%. The differences in rates among these issues are caused primarily by:

Default risk differences.

A zero coupon bond pays no interest. It is offered at par value, which is where it sells initially. These bonds provide compensation to investors in the form of capital appreciation.

False

If the appropriate rate of interest on a bond is greater than its coupon rate, the market value of that bond will be above par value.

False

Of the many factors that affect the cost of money, one of the four most fundamental factors is the expected rate of inflation. A predictable correlation between inflation and interest rates is this: If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

False

The "penalty" for having a low bond rating is less severe when the Security Market Line is relatively steep than when it is not so steep.

False

There is a direct relationship between bond ratings and the required rate of return on bonds; that is, the higher the rating, the higher is the required rate of return.

False

We should expect to see interest rates decline if the federal deficit increased sharply from one year to the next, the Federal Reserve kept the money supply constant, and all other things held constant.

False

Which of the following statements is false? In all of the statements, assume that "other things are held constant."

For a given bond of any maturity, a given percentage point increase in the going interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.

Which of the following statements about interest rates is CORRECT, all other things held constant?

If expected inflation increases, interest rates are likely to increase.

Which of the following statements about the yield curve is CORRECT?

If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.

A noncallable 10-year T-bond has a 12% annual coupon, the yield curve is flat, and it has a10% yield to maturity. A 15-year noncallable T-bond has an 8% annual coupon, the yield curve is flat, and is has a 10% yield to maturity. Which of the following statements is CORRECT?

If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price.

Which of the following statements about bond price risk is CORRECT, assuming that all else is equal?

Long-term bonds have less reinvestment risk than short-term bonds.

Family Traditions Home Fashions would call its outstanding callable bonds if:

Market interest rates decline sharply.

Which of the following statements about sinking funds is CORRECT?

Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued.

Apply the pure expectations theory to the following: Assume that the real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future but that inflation is expected to increase steadily over the next 30 years, giving the Treasury yield curve an upward slope. You are considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity, both of which have the same default and liquidity risks. Again, assuming the pure expectations theory holds, which of these statements is CORRECT?

The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Eagle Enterprises Inc. can issue a 20-year bond with a 6% annual coupon at par. This bond is not convertible, not callable, and has no sinking fund. On the other hand, Eagle Enterprises could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Eagle Enterprises would have to pay on the second bond, the convertible, callable bond with the sinking fund, to have it sell initially at par?

The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the real world the convertible feature would probably cause the coupon rate to be less than 6%.

Assume that the rate on a 1-year bond is now 6%. Investors expect 1-year rates to be 7% one year from now and then 8% two years from now. If the pure expectations theory holds, so that the maturity risk premium equals zero, which of the following statements would be CORRECT?

The interest rate today on a 3-year bond should be approximately 7%

Which of the following statements about bond markets is CORRECT?

The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

Suppose that a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, the real risk-free rate is expected to remain constant at 3% in the future, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?

The yield on a 5-year Treasury bond must exceed that of a 2-year Treasury bond.

"Interest rate risk," also known as "price risk," is the risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds.

True

A 20-year, annual coupon bond with one year left to maturity has the same price risk as a 10-year, annual coupon bond with one year left to maturity. Both bonds are of equal risk, have the same coupon rate, and the prices of the two bonds are equal.

True

A common provision in a bond indenture is a sinking fund. Sinking funds require companies to retire bonds on a scheduled basis prior to their final maturity. Many indentures allow the company to acquire bonds for sinking fund purposes by either (1) purchasing bonds on the open market at the going market price or (2) selecting the bonds to be called by a lottery administered by the trustee, in which case the price paid is the bond's face value.

True

A predictable correlation between the demand curve for funds and the supply curve is this: If the demand curve for funds increases but the supply curve remains constant, then the total amount of funds supplied and demanded increase and interest rates in general also increase.

True

If management is sure that the economy is at the peak of a boom and is about to enter a recession, a firm that needs to borrow money should probably use short-term rather than long-term debt.

True

Of the many factors that affect the cost of money, one of the four most fundamental factors is the availability of production opportunities and their expected rates of return. A predictable correlation between production opportunities and interest rates is this: If opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.

True

Of the many factors that affect the cost of money, one of the four most fundamental factors is the risk inherent in a given security. A predictable correlation between risk and required return is this: The higher the risk, the higher the security's required return, other things held constant.

True

Suppose the Fed takes actions that lower expectations for inflation this year by 1 percentage point, but these same actions raise expectations for inflation in Years 2 and thereafter by 2 percentage points. Other things held constant, the yield curve becomes steeper.

True

When the U.S. economy is very strong, the Federal Reserve tends to take action to increase interest rates, but when the U.S. economy is weak, the Federal Reserve tends to decrease interest rates.

True

Of the following statements about default risk, which one is CORRECT?

Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act.

Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require an 8.4% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

$1,105.69 Par value $1,000 Coupon rate 9.5% Periods/year 2 Yrs to maturity 20 Periods = Yrs to maturity x Periods/year 40 Required rate 8.4% Periodic rate = Required rate/2 = I/YR 4.20% PMT per period = Coupon rate/2 x Par value $47.50 Maturity value = FV $1000 N = 40 I/YR = 42 PV = -1105.69 PMT = 47.5 FV is blank

Grossnickle Corporation issued 20-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000 one year ago. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 19 years to maturity?

$1,232.15 Par Value = Maturity value = FV $1000 Coupon Rate 7.5% Years to maturity = N 19 I/YR = 5.5% (coupon rate)(par value) = PMT = $75

Assume that Steed & Associates' bonds have a par value of $1,000, mature in 8 years, and make an annual coupon interest payment of $65. If the market requires an interest rate of 8.2% on these bonds, what is the bond's price?

$903.04 N = 8 I/YR = 8.2% PMT = $65 FV = $1000 PV = -903.01 or 903.04

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

7.70% Real risk-free rate, r* = 4.20% Inflation = 3.10% MRP Years: 4 Per year: 0.10% = 0.40% Yield on t-year T-bond =

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?

9.04%

Hooper Printing, Inc. has a bond issue outstanding with 14 years left to maturity. The bond issue has a 7% annual coupon rate and a par value of $1,000, but due to changes in interest rates, each bond's value has fallen to $749.04. The capital gains yield earned by investors over the last year was 25.10%. What is the expected current yield for the next year on this bond issue?

9.35% The current yield is defined as the annual coupon payment divided by the current price. CY = $70/$749.04 = 9.35%.

Bond market data show the following information: The Treasury yield curve is downward sloping. Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields. On the basis of this information, which of the following statements is most CORRECT?

A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.

Of the following, identify the CORRECT statement.

A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate.

Which of the following would be most likely to lead to increases in nominal interest rates?

A new technology such as the Internet has just been introduced, and it increases investment opportunities.

All else being equal, which of the following would be most likely to increase the coupon rate required for a bond to be issued at par?

Adding a call provision

Imagine that you see a yield curve for a current corporate bond that is upward sloping. What can you determine from this information?

Maturity risk premiums could help to explain the yield curve's upward slope.

If the U.S. Treasury were to issue $50 billion of short-term securities and sell them to the public, what would be the most likely effect on short-term securities' prices and interest rates? Assume that other factors are held constant.

Prices would decline and interest rates would rise.