Business Finance - Chapter 6

What are the cash flows involved in the purchase of a 5-year zero-coupon bond that has a par value of $1,000 if the current price is $800? Assume the market rate of interest is 5 percent.

Pay $800 today and receive $1,000 at the end of 5 years

What is the equation for approximating the nominal rate of return? R = the nominal rate of interest r = the real rate of interest h = the inflation rate

R = r + h

True or false: The dirty price does not include accrued interest.

false

True or false: The higher the coupon rate, the greater the interest rate risk, all other things being equal.

false

A limitation of bond ratings is that they ___

focus exclusively on default risk

If a bond is selling at a discount from its par value, the YTM must be _____ the coupon rate.

greater than

A bond with a BB rating has a ______ than a bond with an BBB rating.

higher risk of default

When interest rates in the market fall, bond values will increase because the present value of the bond's remaining cash flows ___

increases

The nominal rate is found by adding the _____ and the real rate of return.

inflation

A corporate bond's yield to maturity:

is usually not the same as a bond's coupon rate; changes over time

Which of the following are true about a bond's face value?

it is also known as the par value; It is the principal amount repaid at maturity.

What will happen to a bond's time to maturity as the years go by?

it will decline

The bonds of a firm in financial distress may have a market value that is _______ than the face value at maturity.

less

Which of the following is true of zero coupon bonds?

No coupon payments are made on the bonds

What does historical data suggest about the nature of short-term and long-term interest rates?

Sometimes short-term rates are higher and sometimes long-term rates are higher.

If you are holding two identical bonds, except that one matures in 10 years and the other matures in 5 years, which bond's price will be more sensitive to interest rate risk?

The 10-year one

What does the AAA rating assigned by S&P mean?

The firm is in a strong position to meet its debt obligations

Which of the following are features of municipal bonds?

The interest on municipal bonds is exempt from federal taxes; The interest on municipal bonds is, in some cases exempt from state taxes in the state of issue; They are issued by state and local governments.

What are the three components that influence the Treasury yield curve?

The interest rate risk premium; The real rate of return; Expected future inflation

What does the clean price for a bond represent?

The quoted price excluding accrued interest

Which of the following are usually included in a bond's indenture?

The total amount of bonds issued; The repayment arrangements

Junk bonds have the following features:

They are rated below investment grade bonds

True or false: Zero coupon bond calculations use semiannual periods to be consistent with coupon bond calculations.

true

True or false: The price you actually pay to purchase a bond will generally exceed the clean price.

true

A debenture is a(n) _____ bond, for which no specific pledge of property is made.

unsecured

ABC Co. issued 1 million 6 percent annual coupon bonds that mature in 10 years. The face value is $1,000 per bond. What are the expected cash flows from one of these bonds?

$60 in interest at the end of each year for 10 years and a $1,000 repayment of principal at the end of 10 years.

Which of the following is not a difference between debt and equity?

Equity is publicly traded while debt is not

As a general rule, which of the following are true of debt and equity?

Equity represents an ownership interest; The maximum reward for owning debt is fixed.

Which three components determine the shape of the term structure of interest rates?

Inflation premium; Real interest rate; Interest rate risk premium

What are some features of the OTC market for bonds?

The OTC has no designated physical location; OTC dealers are connected electronically

What does a bond's rating reflect?

The ability of the firm to repay its debt and interest on time

If you are holding two bonds - one with a 5% coupon rate and the other with an 8% coupon rate - which one is more sensitive to interest rate risk, all other things being equal?

The bond with an 8% coupon rate

The coupon payments on floating-rate bonds are _

adjustable

The price is also called the "full" or "invoice" price.

dirty

Which of the following may increase the yield on corporate bonds as compensation to investors but will not impact Treasury bond yields?

liquidity premium; default risk premium

The interest rate risk premium is the additional compensation demanded by investors for holding ____ bonds.

longer-term

The model that precisely specifies the relationship between the nominal rate and the real rate is: R = the nominal rate r = the real rate h = the rate of inflation

(1 + R) = (1 + r)×(1 + h)

Why is the bond market less transparent than the stock market?

Many bond transactions are negotiated privately.

The term structure of interest rates describes _

- the relationship between nominal rates and time to maturity - the pure time value of money

If you are holding a municipal bond that is trading at par to yield 6%, by how much will your after-tax yield change if your federal income tax bracket increases from 15% to 20%. Assume there are no state or local taxes

0%

If you are in the 20% federal income tax bracket, what is your after-tax yield on a municipal bond that is currently trading at par to yield 5%. Assume there are no state or local taxes.

5%

Crossover bonds can also be called _____ bonds.

5B

Which one of the following is the most important source of risk from owning bonds?

Market interest rate fluctuations

What are municipal bonds?

Bonds that have been issued by state or local governments

What are crossover bonds?

Bonds that have both an investment grade and a junk bond rating

What are "fallen angel" bonds?

Bonds that have dropped from investment grade to junk bond status

As an investor in the bond market, why should you be concerned about changes in interest rates?

Changes in interest rates cause changes in bond prices.

What is a bond's current yield?

Current yield = Annual coupon payment/Price

What is a discount bond?

Discount bonds are bonds that sell for less than the face value.

What is a real rate of return?

It is a percentage change in buying power; It is a rate of return that has been adjusted for inflation.

Which of the following are true about a bond's face value?

It is also known as the par value.; It is the principal amount repaid at maturity.

What is a bond's accrued interest?

It is interest that has been earned but not yet received by the current bondholder

What is the nominal rate of return on an investment?

It is the actual percentage change in the dollar value of an investment unadjusted for inflation.

What is the definition of a bond's time to maturity?

It is the number of years until the face value is paid off

What is the bid price?

It is the price an investor will receive if he sells a bond to a dealer; It is the price at which a dealer is willing to buy securities.

What is the asked price?

It is the price at which an investor can buy a particular security from a dealer; It is the price at which a dealer is willing to sell a particular security.

What does a Treasury yield curve show?

It shows the yield for different maturities of Treasury notes and bonds

Which of these correctly identify differences between U.S. Treasury bonds and corporate bonds?

Treasury bonds offer certain tax benefits to investors that corporate bonds cannot offer; Treasury bonds are issued by the US government while corporate bonds are issued by corporations; Treasury bonds are considered free of default risk while corporate bonds are exposed to default risk

What are the two unique features of a U.S. federal government bond?

U.S. Treasury issues are considered to be default-free; U.S. Treasury issues are exempt from state income taxes.

When long-term rates are higher than short-term rates, which of the following shapes will the term structure of interest rates usually have?

Upward sloping

What is a corporate bond's yield to maturity (YTM)?

YTM is the prevailing market interest rate for bonds with similar features; YTM is the expected return for an investor who buys the bond today and holds it to maturity.

What four variables are required to calculate the value of a bond?

Yield to maturity Time remaining to maturity Coupon rate Par value

What is a premium bond?

a bond that sells for more than face value

A bond's coupon payment is:

a fixed amount of interest that is paid annually or semiannually by the issuer to its bondholders

Which of the following are bonds that have actually been issued?

a put bond; a CoCo bond; a convertible bond

To find the total bond value, add the present value of the amount paid at maturity to the _____ of the annual coupon payments

annuity present value

If bonds for AT&T are quoted at 115, they can be purchased:

at 115% of par value plus accrued interest

If a $1,000 face value U.S. Treasury bond is quoted at 99.5, then the bond can be purchased _

at 99.5 percent of face value plus any accrued interest

A provision in the bond indenture giving the issuing company the option to repurchase the bonds before maturity is termed a _________________.

call provision

A bond's ____ payment is a fixed amount of interest that is paid annually or semiannually by the issuer to its bondholders

coupon

Which of the following terms apply to a bond?

coupon rate, par value, time to maturity

When interest rates in the market rise, we can expect the price of bonds to

decrease

A key difference between interest payments and dividend payments is?

dividends are not tax deductible; interest is tax deductible

Debt cannot be subordinated to

equity

True or false: A debenture is a bond secured with collateral.

false

True or false: Bond ratings are concerned only with the possibility of price changes.

false

True or false: Bonds that have dropped into junk territory are called "trash" bonds.

false

If a $1,000 par value bond is trading at a discount, it means that the market value of the bond is ______$1,000.

less than

When using trial and error to compute the yield to maturity (YTM) for a 6 percent coupon bond that trades at a premium, the process can be shortened if the initial guess is ____ 6 percent.

lower than

A zero-coupon bond is a bond that ____.

makes no interest payments

Bonds issued by state and local governments are called __

municipal bonds

Which of the following variables is NOT required to calculate the value of a bond?

original issue price of the bond

Equity represents a(n) interest of a firm.

ownership

What are the two major forms of long-term debt?

public issue and private issue

The term structure of interest rates examines the ___

relationship between short-term and long-term interest rates

Which type of debt is given preference in the event of default?

senior

What is the inflation premium?

t is the additional return demanded by investors to compensate for expected inflation

The relationship between nominal rates, real rates and inflation is called __

the Fisher effect

Bond ratings are based on the probability of default risk, which is the risk that ___

the bond's issuer may not be able make all the required payments

The degree of interest rate risk depends on _

the sensitivity of the bond's price to interest rate changes

The degree of interest rate risk depends on ____.

the sensitivity of the bond's price to interest rate changes

Which of the following are true of bonds?

they are issued by both corporations and governments; They are normally interest-only loans

The sensitivity of a bond's price to interest rate changes is dependent on which of the following two variables?

time to maturity; coupon rate

If a $1,000 par value bond is trading at a premium, the bond is:

trading for more than $1,000 in the market

The US government borrows money by issuing:

treasury notes; treasury bonds

True or false: A put bond allows the holder to force the issuer to buy the bond back at a stated price.

true

True or false: All else being equal, a one-year bond's price is less sensitive to interest rate changes as compared to that of a ten-year bond's price.

true

True or false: In general, the price that is paid for a bond will exceed its quoted price.

true

True or false: Investors require a premium for the risk that issuers other than the Treasury may not make all promised payments on the issued bonds.

true

True or false: Long-term debt has maturities greater than one year.

true

True or false: Longer-term bonds have greater interest rate sensitivity because a large portion of a bond's value comes from the face amount.

true

True or false: Low-grade bonds may not be rated by major rating agencies.

true

True or false: The government sells Treasury notes and bonds to the public every month.

true

Which three of the following are common shapes for the term structure of interest rates?

upward sloping, downward sloping, hump

Most of the time, a floating-rate bond's coupon adjusts _

with a lag to some base rate