Module 4

10. There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False

Answer: a. True

8. A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at par. These bonds provide compensation to investors in the form of capital appreciation. a. True b. False

Answer: b. False

30. Moerdyk Corporation's bonds have a 15-year maturity, an 8.45% 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? a. $1,217.68 b. $1,133.34 c. $1,243.02 d. $1,215.70 e. $1,265.92

Answer: a. $1,217.68 Explanation: Par value = FV $1,000 Coupon rate 8.45% Periods/year 2 Yrs to maturity 15 Periods = Years × 2 = N 30 Going annual rate = YTM = rd 6.20% Periodic rate = rd / 2 = I/YR 3.10% Coupon rate × Par / 2 = PMT $42.25 PV $1,217.68

25. Morin Company's bonds mature in 6 years, have a par value of $1,000, and make an annual coupon interest payment of $65. The market requires an interest rate of 7.9% on these bonds. What is the bond's price? a. $935.08 b. $958.89 c. $880.82 d. $926.86 e. $1,301.40

Answer: a. $935.08 Explanation: N 6 I/YR 7.9% PMT $65 FV $1,000 PV $935.08

22. Kern Corporation's 5-year bonds yield 8.10% and 5-year T-bonds yield 4.90%. The real risk-free rate is r* = 3.40%, the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on Kern's bonds is LP = 1.30%, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on all 5-year bonds? a. 1.10% b. 0.60% c. 2.60% d. 1.90% e. 1.06%

Answer: a. 1.10% Explanation: Maturity 5 rKern Yield 8.10% rT-bond Yield 4.90% r* Included in both bonds 3.40% LP Included in Kern's only 1.30% DRP Included in Kern's only 1.90% MRP Included in both bonds (t - 1) × 0.1% 0.40% rT-bond = r* + IP + MRP rKern = r* + IP + MRP + DRP + LP IP = rKern - r* - LP - MRP - DRP = 1.10% Or, IP = rT-bond - r* - MRP = 1.10%

24. Suppose the real risk-free rate is 3.45% and the future rate of inflation is expected to be constant at 2.50%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Include cross-product terms, i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.) a. 6.04% b. 3.45% c. 3.54% d. 2.59% e. 5.95%

Answer: a. 6.04% Explanation: Real risk-free rate, r* 3.45% Inflation 2.50% Yield on 1-year T-bond = (1 + r*)(1 + IP) - 1 = 6.04%

15. Which of the following statements is CORRECT? a. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. b. Bonds are exposed to both reinvestment risk and price risk. Longer-term low-coupon bonds, relative to shorter-term high-coupon bonds, are generally more exposed to reinvestment risk than price risk. c. Other things held constant, including the coupon rate, a corporation would rather issue noncallable bonds than callable bonds. d. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond because it would have a shorter expected life. e. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value.

Answer: a. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value.

16. Which of the following statements is CORRECT? a. The market price of a bond will always approach its par value as its maturity date approaches, provided the bond's required return remains constant. b. Bonds issued by larger companies always have lower yields to maturity (due to less risk) than bonds issued by smaller companies. c. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices. d. The total yield on a bond is derived from dividends plus changes in the price of the bond. e. Bonds are generally regarded as being riskier than common stocks, and therefore bonds have higher required returns.

Answer: a. The market price of a bond will always approach its par value as its maturity date approaches, provided the bond's required return remains constant.

4. The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT? a. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond. b. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond. c. The yield on a 2-year T-bond must exceed that on a 5-year T-bond. d. The conditions in the problem cannot all be true--they are internally inconsistent. e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

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

1. If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve. a. True b. False

Answer: a. True

11. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if market interest rates are below 10% and at a discount if interest rates are greater than 10%. a. True b. False

Answer: a. True

2. One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant. a. True b. False

Answer: a. True

9. The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity. a. True b. False

Answer: a. True

29. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures from historical book values to market values. KJM Corporation's balance sheet (book values) as of today is as follows: Long-term debt (bonds, at par) $23,500,000 Preferred stock 3,000,000 Common stock ($10 par) 11,000,000 Retained earnings 5,000,000 Total debt and equity $42,500,000 The bonds have an 8.7% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 20 years from today. The yield to maturity is 12%, so the bonds now sell below par. What is the current market value of the firm's debt? Do not round your intermediate calculations. a. $17,707,446 b. $17,665,798 c. $19,540,000 d. $17,635,666 e. $18,588,663

Answer: b. $17,665,798 Explanation: Calculate the price of each bond: Coupon rate 8.7% Par value = FV $1,000 Yrs to maturity 20 Periods/Yr. 2 Periods = Years × 2 = N 40 Going annual rate = rd = YTM 12.0% Periodic rate = rd / 2 = I/YR 6.0% Coupon rate × Par / 2 = PMT $43.50 Price of the bonds = PV $751.74 Determine the number of bonds: Book value on balance sheet $23,500,000 Par value $1,000 Number of bonds = Book value/Par value 23,500 Calculate the market value of bonds: Mkt value = PV × Number of bonds = $17,665,798

28. Keenan Industries has a bond outstanding with 15 years to maturity, a 7.95% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.10% nominal yield to maturity, but it can be called in 4 years at a price of $1,055. What is the bond's nominal yield to call? Do not round your intermediate calculations. a. 1.49% b. 4.28% c. 2.14% d. 4.43% e. 3.24%

Answer: b. 4.28% Explanation: First, use the given data to find the bond's current price. Then use that price to find the YTC. Coupon rate 7.95% YTM 6.10% Maturity 15 Yrs to call 4 Par value $1,000 Call price $1,055 Periods/year 2 Determine the bond's YTC Determine the bond's price N 8 PMT/period $39.75 PV $1,180.14 N 30 PMT $39.75 I/YR 3.05% FV $1,055.00 FV $1,000.00 I/YR 2.14% PV = Price $1,180.14 Nom. YTC 4.28%

27. Sadik Inc.'s bonds currently sell for $1,300 and have a par value of $1,000. They pay a $105 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100. What is their yield to call (YTC)? a. 8.08% b. 5.31% c. 5.81% d. 7.49% e. 7.17%

Answer: b. 5.31% Explanation: N 5 PV $1,300 PMT $105 FV $1,100 I/YR = YTC 5.31%

12. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond. a. True b. False

Answer: b. False Explanation: The callable bond will be called if rates fall far enough below the coupon rate, but it will not be called otherwise. Thus, the call provision can only harm bondholders. Therefore, callable bonds sell at higher yields than noncallable bonds, regardless of the slope of the yield curve.

17. Which of the following statements is CORRECT? a. If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon rate. b. If a coupon bond is selling at par, its current yield equals its yield to maturity. c. If rates fall after its issue, a zero coupon bond could trade at a price above its maturity (or par) value. d. If rates fall rapidly, a zero coupon bond's expected appreciation could become negative. e. If a firm moves from a position of strength toward financial distress, its bonds' yield to maturity would probably decline.

Answer: b. If a coupon bond is selling at par, its current yield equals its yield to maturity.

19. Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, 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. a. 1, 2, 3, 4, 6 b. 1, 4, 6 c. 1, 3, 4, 6 d. 1, 2, 3, 4, 5, 6 e. 1, 3, 4, 5, 6

Answer: c. 1, 3, 4, 6

26. Adams Enterprises' noncallable bonds currently sell for $900. They have a 20-year maturity, an annual coupon of $95, and a par value of $1,000. What is their yield to maturity? a. 10.56% b. 11.97% c. 10.73% d. 10.76% e. 6.02%

Answer: c. 10.73% Explanation: N 20 PV $900 PMT $95 FV $1,000 I/YR 10.73%

20. A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT? a. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future. b. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond. c. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds. d. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan. e. If two classes of debt are used (with one senior and the other subordinated to all other debt), the subordinated debt will carry a lower interest rate.

Answer: c. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds. Explanation: In "If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds", note that if only $500,000 of 1st mortgage bonds were secured by $1 million of property, each of those bonds would be less risky than if there were $1 million of bonds backed by the $1 million of property. Note too that the cost of the total $1 million of debt would be an average of the cost of the mortgage bonds and the debentures, and that average cost could be higher, lower, or the same as if only mortgage bonds or only debentures were used.

13. Which of the following statements is CORRECT? a. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less price risk. b. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold. c. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more price risk but less reinvestment risk. d. Long-term bonds have less price risk but more reinvestment risk than short-term bonds. e. Long-term bonds have less price risk and also less reinvestment risk than short-term bonds.

Answer: c. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more price risk but less reinvestment risk.

7. Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT? a. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds. b. The stated conditions cannot all be true - they are internally inconsistent. c. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities. d. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope. e. The yield on any corporate bond must exceed the yields on all Treasury bonds.

Answer: c. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.

3. If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? a. The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium. b. The yields on the two securities would be equal. c. The yield on a 10-year bond would be less than that on a 1-year bill. d. It is impossible to tell without knowing the coupon rates of the bonds. e. It is impossible to tell without knowing the relative risks of the two securities.

Answer: c. The yield on a 10-year bond would be less than that on a 1-year bill.

5. Which of the following statements is CORRECT? a. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond. b. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond. c. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. d. The real risk-free rate should increase if people expect inflation to increase. e. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

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

6. The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation is expected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that the pure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements is CORRECT? a. Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds. b. The 10-year Treasury bond must have a higher yield than the 5-year corporate bond. c. Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds. d. The 10-year corporate bond must have a higher yield than the 5-year corporate bond. e. Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond.

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

23. Niendorf Corporation's 5-year bonds yield 7.70%, and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 1.95%, the inflation premium for 5-year bonds is IP = 2.05%, the default risk premium for Niendorf's bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Niendorf's bonds? a. 2.90% b. 3.30% c. 1.65% d. 2.50% e. 2.10%

Answer: e. 2.10% Explanation: Basic equation: r = r* + IP + MRP + DRP + LP Years to maturity: 5 MRP In both bonds, so not needed in this problem 0.40% IP In both bonds, so not needed in this problem 2.05% r* In both bonds, so not needed in this problem 1.95% rNie 7.70% rT-bond 4.40% DRP Included in corp. only 1.20% LP = rNie - rT-bond - DRP 2.10%

21. Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 2.70%. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 2.60% b. 2.50% c. 3.95% d. 2.86% e. 5.20%

Answer: e. 5.20% Explanation: Real risk-free rate, r* 2.50% Inflation 2.70% Yield on 5-year T-bond 5.20%

14. A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following statements is CORRECT? a. The bond sells at a price below par. b. The bond sells at a discount. c. The bond's required rate of return is less than 7.5%. d. The bond has a current yield greater than 8%. e. If the yield to maturity remains constant, the price of the bond will decline over time.

Answer: e. If the yield to maturity remains constant, the price of the bond will decline over time.

18. Which of the following statements is CORRECT? a. A 10-year coupon bond would have more price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of price risk. b. If their maturities and other characteristics were the same, a 5% coupon bond would have less price risk than a 10% coupon bond. c. A 10-year coupon bond would have more reinvestment risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment risk. d. A zero coupon bond of any maturity will have more price risk than any coupon bond, even a perpetuity. e. If their maturities and other characteristics were the same, a 5% coupon bond would have more price risk than a 10% coupon bond.

Answer: e. If their maturities and other characteristics were the same, a 5% coupon bond would have more price risk than a 10% coupon bond.