Finance Ch. 6

A call feature in a bond allows bondholders to change each bond into a stated number of shares of common stock.

False

The legal contract setting forth the terms and provisions of a corporate bond is a(n) ________.

Indenture

The price of a bond with a fixed coupon rate and the required return have a relationship that is best described as ________.

Inverse

________ mainly explains the tendency for the yield curve to be upward sloping

Liquidity preference theory

Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied.

True

The bond indenture identifies any collateral pledged against a bond and specifies how it is to be maintained.

True

The call option in a bond has a greater chance of being exercised (to the detriment of the bondholder) if market interest rates have fallen since the bond was issued.

True

The components of risk premium includes business risk, financial risk, interest rate risk, liquidity risk, and tax risk.

True

The expectations theory suggests that the shape of the yield curve reflects investors expectations about future interest rates.

True

In the valuation process, the higher the risk, the greater is the required return.

True

A bond will sell ________ when the stated rate of interest exceeds the required rate of return, ________ when the stated rate of interest is less than the required return, and ________ when the stated rate of interest is equal to the required return. A) at a premium; at a discount; equal to the par value B) at a premium; equal to the par value; at a discount C) at a discount; at a premium; equal to the par value D) equal to the par value; at a premium; at a discount

A

A foreign bond is issued by a(n) ________. A) foreign corporation or government and is denominated in the investor's home currency and sold in the investor's home market B) corporation or government and is denominated in the investor's foreign currency and sold in the foreign market C) international borrower and sold to investors in countries with currencies other than the local currency D) international borrower and sold to investors in countries with currencies in which the bond is denominated

A

Convertible bonds are normally ________. A) debentures B) income bonds C) zero coupon bonds D) mortgage bonds

A

Danno is trying to decide which of two bonds to buy. Bond H is a 10 percent coupon, 10-year maturity, $1,000 par, January 1, 2000 issue paying annual interest. Bond F is a 10 percent coupon, 10-year maturity, $1,000 par, January 1, 2000 issue paying semiannual interest. The market required return for each bond is 10 percent. When using present value to determine the prices of the bonds, Danno will find that ________. A) there is no difference in price B) the price of F is greater than H C) the price of H is greater than F D) he needs more information before determining the prices.

A

ABC company has two bonds outstanding that are the same except for the maturity date. Bond D matures in 4 years, while Bond E matures in 7 years. If the required return changes by 5 percent, then ________. A) bond D will have a greater change in price B) bond E will have a greater change in price C) the price of the bonds will be constant D) the percentage price change for the bonds will be equal

B

An example of a standard debt provision is to ________. A) limit the corporation's annual cash dividend payments B) pay taxes and other liabilities when due C) restrict the corporation from disposing of fixed assets D) maintain a minimum level of liquidity

B

If the coupon rate of a bond is equal to its required rate of return, then ________. A) the current value is not equal to par value B) the current value is equal to par value C) the maturity value is equal to par value D) the current value is equal to maturity value

B

A(n) ________ is secured by real estate. A) income bond B) debenture C) mortgage bond D) subordinated debenture

C

________ are debt rated Ba or lower by Moody's or BB or lower by Standard & Poor's and are commonly used by rapidly growing firms to obtain growth capital, most often to finance mergers and takeovers. A) Subordinated debentures B) Mortgage bonds C) Junk bonds D) Equipment trust certificates

C

The ________ feature permits the issuer to repurchase bonds at a stated price prior to maturity.

Call

An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

False

Any bond rated Aaa through Caa according to Moody's, would be considered investment grade debt.

False

Bondholders will convert their convertible bonds into shares of stock only when the conversion price is greater than the market price of the stock.

False

Floating-rate bonds are bonds that can be redeemed at par at the option of their holder either at specific date after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions such as being acquired, acquiring another company, or issuing a large amount of additional debt.

False

Longer the maturity of a Treasury security, the smaller the interest rate risk.

False

With subordinated debentures, payment of interest by a firm is required only when earnings are available.

False

________ bonds are characterized by interest payments that are required only when earnings are available.

Income

Explain liquidity, default risk, and maturity risk premiums.

Liquidity problems exist in thinly traded bonds, default risk is the likelihood the corporation will default on its bond obligations, and the maturity risk reflects the fact that longer-term bonds possess greater interest rate risk and sensitivity than shorter term bonds. If any of these exists, investors will demand compensation for the risk by demanding a yield premium to own the bonds.

________ rate of interest is the actual rate charged by the supplier and paid by the demander of funds.

Nominal

________ rate of interest creates equilibrium between the supply of savings and the demand for investment funds.

Real

A ________ give bondholders the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time.

Stock purchase warrant

________ allow bondholders to purchase a certain number of shares of the firm's common stock at a specified price over a certain period of time.

Stock purchase warrants

________ means that subsequent creditors agree to wait until all claims of the are senior debt satisfied before having their claims satisfied.

Subordination

In theory, the rate of return on U.S. Treasury bills should always exceed the rate of inflation as measured by the consumer price index.

True

Upward-sloping yield curves result from higher future inflation expectations, lender preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term loans relative to their respective demand.

True

Valuation is the process that links risk and return to determine the worth of an asset.

True

When a bond's required return is greater than its coupon interest rate, the bond value will be less than its par value.

True

When a bond's value differs from par, its yield to maturity will differ from its coupon interest rate.

True

When the required return is different from the coupon interest rate and is constant until maturity, the value of the bond will approach its par value as it nears maturity.

True

Yield to call represents the rate of return that investors earn if they buy a callable bond at a specific price and hold it until it is called back and they receive the call price, which would be set above the bond's par value

True

Yield to maturity (YTM) is the rate investors earn if they buy the bond at a specific price and hold it until maturity.

True

The process that links risk and return in order to determine the worth of an asset is termed ________.

Valuation

If the required return is greater than the coupon rate, a bond will sell at ________.

a discount

On ________, the stated interest rate is adjusted periodically within stated limits in response to changes in specified money or capital market rates.

a floating rate bond

Generally, an increase in risk will result in ________.

a higher required return or interest rate

A debenture is ________.

an unsecured bond that only creditworthy firms can issue

When the required return is constant but different from the coupon rate, the price of a bond as it approaches its maturity date will ________.

approach par

The purpose of the restrictive debt covenant that limits the distribution of profits to shareholders is to ________.

avoid default of payments to bondholders

A type of long-term financing used by both corporations and government entities is ________.

bonds

To compensate for the uncertainty of future interest rates and the fact that the longer the term of a loan the higher the probability that the borrower will default, the lender typically ________.

charges a higher interest rate on long-term loans

The ________ in the capital market is the basis for determining a bond's coupon interest rate.

cost of money

Assume the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based on this information, the shape of the yield curve is ________.

downward sloping

The yield curve in an economic period where lower future inflation is expected would be ________.

downward-sloping

The purpose of the debt covenant that requires maintaining a minimum level of net working capital is to ________.

ensure a cash shortage does not cause an inability to meet current obligations

A yield curve that reflects relatively similar borrowing costs for both short-term and long-term loans is called as ________.

flat yield curve

A(n) ________ gives purchasers inflation protection.

floating rate bond

Bond indentures include restrictive covenants.These provisions protect the bondholders against ________.

increase in borrower's risk

The size of a loan and its issuance costs (as a percentage of the amount borrowed) are ________.

inversely related

A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs is called ________.

inverted yield curve

The purpose of the debt covenant that prohibits borrowers from entering into certain types of leases is to ________.

limit the amount of fixed-payment obligations

The purpose of the restrictive debt covenant that prohibits the sale of accounts receivable is to ________.

limit the realization of current assets to cash

The theory suggesting that for any given issuer, long-term interest rates tends to be higher than short-term rates is called ________.

liquidity preference theory

Which of the following affects the slope of yield curve?

liquidity preferences

Nico invested an amount a year ago and calculated his return on investment. He found that his purchasing power had increased by 15 percent as a result of his investment. If inflation during the year was 4 percent, then Nico's ________.

nominal return on investment is more than 15 percent

An upward-sloping yield curve that indicates cheaper short-term borrowing costs than long-term borrowing costs is called as ________.

normal yield curve

A $1,000, 8% bond sells for 980. $1,000 is called the ________.

par value

The purpose of the restrictive debt covenant that imposes fixed assets restrictions is to ________.

prevent the firm from liquidation and ensure its ability to repay the debt

The riskiness of publicly traded bond issues is rated by independent agencies. According to Moody's rating system, an Aaa bond and a Caa bond are ________ and ________ respectively.

prime quality; speculative

The purpose of the restrictive debt covenant that requires that subsequent borrowing be subordinated to the original loan is to ________.

protect the original lender in the priority of claims during liquidation

The ________ rate is typically the nominal rate of interest on a three-month U.S. Treasury bill.

risk-free

A ________ is a restrictive provision in a bond indenture, providing for the systematic retirement of the bonds prior to their maturity.

sinking-fund requirement

The current yield on a bond is measured by ________.

the annual interest payment divided by the current price

The term structure of interest rates is the relationship between ________.

the maturity and rate of return for bonds with similar level of risk

Stock purchase warrants are instruments that give their holders ________.

the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time

Nominal rate of interest is equal to ________.

the risk-free rate plus a risk premium

Which of the following is a restrictive covenant?

to impose fixed asset restrictions

A(n) ________ is a paid individual, corporation, or a commercial bank trust department that acts as a third party to a bond indenture.

trustee

A(n) ________ yield curve reflects higher expected future rates of interest.

upward-sloping

The yield curve in an economic period where higher future inflation is expected would be ________.

upward-sloping

A(n) ________ is a graphic depiction between the maturity and rate of return for bonds with similar risks.

yield curve

For an investor who plans to purchase a bond maturing in one year, the primary consideration should be ________.

yield to maturity

The ________ is the compound annual rate of interest earned on a debt security purchased on a given date and held to maturity.

yield to maturity

Deeply discounted bond that pays no coupon interest is a ________.

zero coupon bond

A(n) ________ is issued with no or very low coupon and sells significantly below its par value.

zero or low coupon bond

Debentures such as convertible bonds are unsecured bonds that only the most creditworthy firms can issue.

True

Duration measures the sensitivity of a bond's prices to changing interest rates.

True

An interest rate or a required rate of return represents the cost of money.

True

Any Ba rated bond or lower would be considered speculative or "junk."

True

A bond will sell at a premium when its required return rises above its coupon interest rate.

False

If a corporate bond is issued with a coupon rate that varies directly with the required return, the price of the bond will ________. A) equal the face value B) be less than the face value C) be greater than the face value D) be greater than or less than the face value depending on how interest rates vary

A

When the required return is constant and equal to the coupon rate, the price of a bond as it approaches its maturity date will ________. A) remain at par B) increase C) decrease D) change depending on whether it is a discount or premium bond

A

Which of the following affects the cost of a bond? A) maturity of a bond B) dividend policy C) fixed assets purchased from the proceeds of bond issue D) money market regulations

A

Payment of interest required only when earnings are made available from which to make a payment is characteristic of a(n) ________. A) floating rate bond B) income bond C) mortgage bond D) equipment trust certificate

B

Stated interest rate under ________ is adjusted periodically within stated limits in response to changes in specified money market or capital market rates. A) junk bonds B) floating rate bonds C) extendible notes D) putable bonds

B

The key inputs to the valuation process include ________. A) returns and risk B) cash flow, cash flow timing, and risk C) cash flows and discount rate D) returns, discount rate, and risk

B

The return expected from an asset is fully defined by its ________. A) risk and cash flow B) cash flow and timing C) discount rate D) beta

B

The value of a bond is the present value of its interest payments plus ________. A) future value of its par value B) present value of its par value C) its face value D) present value of interest payment

B

The value of any asset is the ________. A) sum of all future cash flows it is expected to provide over the relevant time period B) sum of the present values of all future cash flows it is expected to provide over the relevant time period C) present value of the sum of all future cash flows it is expected to provide over the relevant time period D) sum of all compounded future cash flows it is expected to provide over the relevant time period

B

When issuing a(n) ________ the issuer can annually deduct the current year's interest accrual without having to actually pay the interest until the bond matures. A) junk bond B) zero coupon bond C) floating rate bond D) extendible note

B

________ are claims that are not satisfied until those of the creditors holding certain (senior) debts have been fully satisfied. A) Convertible debentures B) Subordinated debentures C) Mortgage bonds D) Collateral trust bonds

B

________ are popular vehicle used to finance mergers and takeovers. A) Income bonds B) Junk bonds C) Floating rate bonds D) Convertible debentures

B

________ have a short maturities, typically one to five years, and which can be renewed for a similar period at the option of their holders. A) Floating rate bonds B) Extendible notes C) Putable bonds D) Junk bonds

B

A significant portion of the return on a zero coupon bond is in the form of ________. A) interest and gain in value B) interest C) gain in value D) tax reduction

C

Bonds are ________. A) a series of perpetual short-term debt instruments B) a form of equity financing that pays interest C) long-term debt instruments used to raise large sums of money D) a hybrid form of financing used to raise large sums of money from a diverse group of lenders

C

Bonds which sell at less than face value are priced at a ________, while bonds which sell at greater than face value sell at a ________. A) par; premium B) discount; par C) discount; premium D) coupon; premium

C

Less certain a cash flow, the ________ the risk, and ________ the present value of the cash flow. A) lower; higher B) lower; lower C) higher; lower D) higher; higher

C

The cost of a long-term debt generally ________ that of a short-term debt. A) is less than B) is equal to C) is greater than D) is less than or equal to

C

The decision to refund a callable bond ________. A) should be made only if interest rates have increased B) is a net working capital decision C) is a capital budgeting decision D) is an investing decision

C

Yield to maturity on a bond with price equal to its par value will ________. A) be less than the coupon rate B) be more than the coupon rate C) always be equal to the coupon rate D) be less than or equal to the coupon rate depending on the required return

C

________ are secured by stock and/or bonds that are owned by the issuer. A) Mortgage bonds B) Equipment trust certificates C) Collateral trust bonds D) Subordinated debentures

C

The ________ feature allows bondholders to change each bond into stated number of shares of stock.

Conversion

A debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms is called a(n) ________.

Corporate Bond

A putable bond gives the bondholder ________. A) the right to sell the bond back to the corporation at a discount B) the right to sell the bond back to the corporation at a stated premium C) the right to redeem the bond back to the corporation at the current market value D) the right to redeem the bond back to the corporation at par

D

Bonds that can be redeemed at par at the option of their holders either at specific date after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions such as being acquired, acquiring another company, or issuing a large amount of additional debt are called ________. A) zero coupon bonds B) junk bonds C) floating-rate bonds D) putable bonds

D

Corporate bonds have a ________. A) face value of $5,000 B) market price of $1,000 C) specified coupon rate paid annually D) par value of $1,000

D

High-risk, high-yield junk bonds have declined in popularity over time due to ________. A) the decline in mergers and takeovers, which these bonds were used to finance B) the declining need of growth capital C) the stabilizing of interest rates D) a number of major defaults on these bonds

D

The value of a bond is the present value of the ________. A) dividends and maturity value B) interest and dividend payments C) maturity value D) interest payments and maturity value

D

Which of the following is true of risk premium? A) T-bills have a have a higher risk premium than that of Treasury bonds. B) The government bonds have a higher risk premium than that of corporate bonds. C) The speculative corporate issues have a lower risk premium than that of the higher rated corporate issues. D) The lower-rated corporate issues have a higher risk premium than that of the higher rated corporate issues.

D

Interest rate risk and the time to maturity have a relationship that is best characterized as ________.

Direct

In the basic valuation model, risk is generally incorporated into the ________.

Discount rate

A(n) ________ yield curve reflects lower expected future rates of interest.

Downward-sloping

________ is used to finance "rolling stock"—airplanes,trucks,boats,railroad cars.

Equipment trust certificates

Which of the following explains the general shape of the yield curve of a bond?

Expectations theory

A Eurobond bond is a bond denominated in Euros.

False

A call feature in a bond allows the issuer the opportunity to repurchase bonds at a stated price prior to maturity, and this option has a greater chance of being exercised (to the benefit of the bondholder) if market interest rates have fallen since the bond was issued.

False

A call feature is a feature included in all corporate bonds and allows the issuer to repurchase bonds at the market price prior to maturity.

False

A call premium is the amount by which the call price exceeds the market price of the bond.

False

A company's bonds will experience more trading activity (in terms of the number of bonds traded on a given day) compared to its stock.

False

A conversion feature in a bond has a greater chance of being exercised (to the detriment of the bondholder) if market interest rates have risen since the bond was issued.

False

A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

False

A flat yield curve indicates generally cheaper long-term borrowing costs than short-term borrowing costs.

False

A nominal rate of interest is equal to the sum of the real rate of interest plus the risk free rate of interest.

False

A real rate of interest is the compensation paid by the borrower of funds to the lender.

False

A trustee is a paid party representing the bond issuer in the bond indenture.

False

A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a normal yield curve.

False

An A rated bond should provide investors with a higher yield than an otherwise identical B rated bond.

False

In a bond indenture, the term "security interest" refers to the fact that most firms that issue bonds are required to establish sinking fund provisions to protect bondholders.

False

Putable bonds give the bondholders an option to sell the bond at a price higher than par value by the amount of one year interest payment when and if the firm takes specified actions such as being acquired, acquiring another company, or issuing a large amount of additional debt.

False

Standard debt provisions specify certain record keeping and general business practices that must be ensured by the bond issuer.

False

Stock purchase warrants are instruments that give their holder the right to purchase a certain number of shares of the firm's common stock at the market price over a certain period of time.

False

The conversion feature of a bond is a feature that is included in all corporate bond issues that gives the issuer the opportunity to repurchase bonds at a stated price prior to maturity.

False

The level of risk associated with a given cash flow positively affects its value.

False

The liquidity preference theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

False

The lower a bond's default risk, the higher is the interest rate.

False

The nominal rate of interest on a bond is 7% and an inflation premium of 3%. This results in a real rate of interest of 4% on the bond.

False

The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called maturity risk.

False

The restrictive debt covenant that imposes fixed assets is to guarantee fixed-payment obligations by maintaining a specified level of fixed assets.

False

The shorter the amount of time until a bond's maturity, the more responsive is its market value to a given change in the required return.

False

The value of an asset depends on the historical cash flow(s) up to the present time.

False

_______ are commonly issued in the reorganization of a failed or failing firm.

Income bonds

An inverted yield curve is a downward-sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.

True

A Eurobond is a bond issued by an international borrower and sold to investors in countries with currencies other than the country in which the bond is denominated.

True

A bond issued by an American company that is denominated in Swiss Francs and sold in Switzerland would be an example of a foreign bond.

True

A bond with short maturity has less "interest rate risk" than a bond with long maturity when all other features—coupon interest rate, par value, and interest payment frequency—are the same.

True

A conversion feature in a bond allows bondholders to change each bond into a stated number of shares of common stock.

True

A flat yield curve means that the rates do not vary much at different maturities.

True

A foreign bond is a bond issued by a foreign corporation or government and is denominated in the investor's home currency and sold in the investor's home market.

True

A normal yield curve is upward-sloping and indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

True

As a bond approaches maturity, the price of the bond will approach its par value until, the bond is worth its face value at maturity.

True

Coupon interest rate on a bond represents the percentage of the bond's par value that will be paid annually, typically in two equal semiannual payments, as interest.

True

High-quality (high-rated) bonds provide lower returns than lower-quality (low-rated) bonds.

True

IBM stock will experience greater trading activity (in terms of the number of shares traded on a given day) compared to IBM bonds.

True

If a bond's required return always equals its coupon interest rate, the bond's value will remain at par until it matures.

True

In a bond indenture, subordination is the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied.

True

In a bond indenture, the term "security interest" refers to collateral pledged against the bond.

True

Increases in the basic cost of long-term funds or in risk will raise the required return on a bond.

True

Interest rate risk is the risk that results from the changes in interest rates and thereby impact the bond value.

True

Longer the maturity, higher is the cost of a bond.

True

Nominal rate of interest is equal to the sum of the real rate of interest plus an inflation premium plus a risk premium.

True

Restrictive covenants are contractual clauses in long-term debt agreements that place certain operating and financial constraints on the borrower.

True

Restrictive covenants place operating and financial constraints on the borrower.

True

Restrictive covenants, coupled with standard debt provisions, help the lender to monitor the borrower's activities to ensure efficient use of funds.

True

Risk-free rate of interest is equal to the sum of the real rate of interest plus an inflation premium.

True

Since a putable bond gives its holder the right to "put the bond" at specified times or because of specified actions by the issuing firm, the bond's yield would be lower than that of an otherwise equivalent non-putable bond.

True

Since the issuer of zero (or low) coupon bonds can annually deduct the current year's interest accrual without having to actually pay the interest until the bond matures (or is called), its cash flow each year is increased by the amount of the tax shield provided by the interest deduction.

True

The liquidity preference theory suggests that for any given issuer, long-term interest rates tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities; this causes the yield curve to be upward-sloping.

True

The liquidity preference theory suggests that short-term interest rates should be lower than long-term interest rates.

True

The market price of a callable bond will not generally exceed its call price, except in the case of a convertible bond.

True

The market segmentation theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

True

The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by demander.

True

The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called default risk.

True

The reason for a difference in the yield between a Aaa corporate bond and an otherwise identical Baa bond is the risk premium; other things being equal.

True

The required return on a bond is likely to differ from the stated interest rate for either of two reasons: 1) economic conditions have changed, causing a shift in the basic cost of long-term funds, or 2) the firm's risk has changed.

True

The term structure of interest rates is a graphical presentation of the relationship between the maturity and rate of return.

True

The value of a bond that pays semiannual interest is greater than that on an otherwise equivalent annual coupon interest paying bond.

True

The value of an asset is determined by discounting the expected cash flows back to its present value, using an appropriate discount rate.

True

The yield to maturity on a bond with a current price equal to its par or face value, will always be equal to the coupon interest rate.

True

There is an inverse relationship between the quality or rating of a bond and the rate of return it must provide bondholders.

True

To carry out systematic retirement of bonds, a corporation makes semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace.

True

To sell a callable bond, the issuer must pay a higher interest rate than on an otherwise equivalent noncallable bond.

True

If the required return is less than the coupon rate, a bond will sell at ________.

a premium

A bond rated Aaa according to Moody's, is considered ________.

a prime quality bond