Finance Exam #3

Bond

a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond.

Cost of debt capital to the firm

when a firm issues bonds, the return that investors require on the bonds

The yield to maturity equals the expected rate of return only when

(1) the probability of default is zero. (2) The bond cannot be called.

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. True False

F

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? Low-coupon bonds have less price risk than high-coupon bonds. Long-term bonds have less reinvestment risk than short-term bonds. High-coupon bonds have less reinvestment risk than low-coupon bonds. Long-term bonds have less price risk than short-term bonds. Short-term bonds have less reinvestment risk than long-term bonds.

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

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. A sinking fund provision makes a bond more risky to investors at the time of issuance. Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature. Sinking fund provisions only establish "targets" for the company to reduce its debt over time, not to retire their debt entirely. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price.

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.

T or F 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.

T

Reinvestment Risk

The risk of an income decline due to a drop in interest rates

coupon payment

The specified number of dollars of interest paid each year.

coupon interest rate.

When this annual coupon payment is divided by the par value, the result is the

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

Of the following, identify the CORRECT statement. A discount bond's price increases each year until it matures, when its value equals its par value. 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. If a bond sells at par, then its current yield will be less than its yield to maturity. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond. A discount bond's price declines each year until it matures, when its value equals its par value.

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.

Maturity Date

A specified date on which the par value of a bond must be repaid.

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? The rating agencies changing the bond's rating from Baa to Aaa Adding additional restrictive covenants that limit management's actions Adding a sinking fund Adding a call provision Making the bond a first mortgage bond rather than a debenture

Adding a call provision

Interest rates on 20-year Treasury and corporate bonds with different ratings, all noncallable, are as follows: The differences in rates among these issues were most probably caused by: Inflation differences. Default and liquidity risk differences. Tax effects. Maturity risk differences. Real risk-free rate differences.

Default and liquidity risk differences.

T or F 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.

F

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. True False

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. True False

False

Which of the following statements is false? In all of the statements, assume that "other things are held constant." From a borrower's point of view, interest paid on bonds is tax deductible. 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. Price sensitivity—that is, the change in price due to a given change in the required rate of return—increases as a bond's maturity increases. For any given maturity, a given percentage point increase in the interest rate causes a smaller dollar capital loss than the capital gain stemming from an identical decrease in the interest rate. A 20-year zero-coupon bond has less reinvestment risk than a 20-year coupon bond.

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.

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 should be slightly greater than 6%. The coupon rate should be over 7%. The coupon rate should be exactly equal to 6%. 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%. The coupon rate should be over 8%.

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%.

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 False

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. Senior debt has more default risk than subordinated debt, all else being equal. Under Chapter 13 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. A company's bond rating is affected by its financial ratios but not by provisions in its indenture. Secured debt is more risky than unsecured debt, all else being equal.

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.

yield to maturity

promised rate of return The rate of return earned on a bond if it is held to maturity.