Ch.6 Finance review

T/F: The price you actually pay to purchase a bond will generally exceed the clean price

True

Pay $800 today and receive $1000 at the end of 5 years

What are the cash flows involved in the purchase of 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%?

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

What are the features of municipal bonds?

- The interest rate risk premium - The real rate of return - Expected inflation

What are the three components that effect the treasury yield curve?

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

What does a Treasury yield curve show?

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

What does a bond's rating reflect?

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

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

- yield to maturity - par value - coupon rate - time remaning to maturity

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

- 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 is a corporate bond's YTM?

- it is a percentage change in buying power - it is a rate of return that has been adjusted for inflation

What is a real rate of return?

Current yield = annual coupon payment / current price

What is bonds current yield?

11.11% 1,000x0.10/ 900 =0.1111

What is the current yield on a $1,000 par value bond that sells for $900 if the coupon rate is 10%?

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

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

it is the actual percentage change in the dollar vaule of an investment adjusted for inflation.

What is the nominal rate of return on an investment?

5.25 % .07 x (1-.25) = 5.25

What will your aftertax yield be on a corporate bond that is currently priced to yield 7% if you are in thr 25 percent tax bracket?

What is a premium bond?

A bond that sells for more than face value

Current yield

A bond's annual coupon divided by its price.

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

A bond's coupon payment is?

a par value bond

A bond that sells for its par value is called?

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

A corporate bond's yield to maturity?

$5,000 per bond

A firm decides to raise money by issuing 5 million bonds with a par value of $5,000 each for 10 years at a coupon rate of 7 percent. At the time of issue, the bonds were sold for $5,500 each. What will the par value of the bonds be in year 5?

- interest is tax deductible - dividends are not tax deductible

A key difference between interest payments and divident payments is?

call provision

A provision in the bond indenture giving the issuing company the option to repurchase the bonds before maturiy is termed a?

pays coupon payments directly to the owner of record.

A registered-form bond is defined as a bond that?

makes no interest payments

A zero-coupon bond is a bond that?

$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

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

- the maximum reward for owning debt is fixed - equity represents an ownership interest

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

changes in interest rates causes changes in bond prices.

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

If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price Price below par = "discount" bond If YTM < coupon rate, then par value < bond price Price above par = "premium" bond

Bond Prices: Relationship Between Coupon and Yield:

Bond Value = PV(coupons) + PV(par) Bond Value = PV(annuity) + PV(lump sum) Remember: As interest rates increase present values decrease As interest rates increase, bond prices decrease and vice versa

Bond Value:

default risk only.

Bond ratings classify bonds based on:

What are crossover bonds?

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

Interest rate risk premium

Changes in interest rates affect bond prices. Which one of the following compensates bond investors for this risk?

Debt: Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax-deductible Creditors have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy Equity: Ownership interest Common stockholders vote to elect the board of directors and on other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm until declared. Stockholders have no legal recourse if no dividends are declared An all-equity firm cannot go bankrupt

Differences between debt and equity:

ownership

Equity in a(n) _____ interest of a firm.

How sensitive its price is to interest rate changes

How much interest rate risk a bond has depends on?

4.6%=approx 6.3-1.7=4.6% 4,52%=exact Exact r = [(1 + .0630) / (1 + .017)] - 1

If Treasury bills are currently paying 6.3 percent and the inflation rate is 1.7 percent, what is the approximate and the exact real rate of interest?

Less than

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

Greater than

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

downward sloping.

If inflation is expected to steadily decrease in the future, the term structure of interest rates will most likely be:

have priority in the purchase of any newly issued shares.

If shareholders are granted a preemptive right they will:

The 10 year bond

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

What is the inflation premium?

It is the additional return demand by investors to compensate for expected inflation

Maturity: Years until bond must be repaid Yield to maturity (YTM): The market required rate of return for bonds of similar risk and maturity The discount rate used to value a bond Return if bond held to maturity Usually = coupon rate at issue Quoted as an APR Par value: Face amount Re-paid at maturity Assume $1,000 for corporate bonds Coupon interest rate: Stated interest rate Usually = YTM at issue Multiply by par value to get coupon payment

Key features of a bond:

= $912.64 N = 6 I/Y = 9.9 PV= ? PMT= -79 FV= -1,000

Lycan, Inc., has 7.9 percent coupon bonds on the market that have 6 years left to maturity. The bonds make annual payments and have a par value of $1,000. If the YTM on these bonds is 9.9 percent, what is the current bond price?

debenture

Miller Farm Products is issuing a 15-year, unsecured bond. Based on this information, you know that this debt can be described as a:

declines

Once the bond has been issued, the number of years to maturity_____ as time goes by.

(1 + R) = (1 + r)(1 + h) R = (1 + .039)(1 + .012) - 1 R = (1.039 x 1.012 ) - 1 R = 5.15%

Suppose the real rate is 3.9 percent and the inflation rate is 1.2 percent. What rate would you expect to see on a Treasury bill?

n=20 i/y= 8 pv=? pmt= -100 fv= -1000 pv= 1,196.36

Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1,000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond

N = number of periods to maturity I/Y = period interest rate = YTM PV = present value = bond value PMT = coupon payment FV = future value = face value = par value

Texas Instruments BA-II Plus:

7.57% Current yield = (.08 ×$1,000)/$1,057 Current yield = .0757 , or 7.57 percent

The 8 percent, $1,000 face value bonds of Sweet Sue Foods are currently selling at $1,057. These bonds have 16 years left until maturity. What is the current yield?

Nominal Return

The R in the Fisher effect formula represents the:

8.4 % N=11 I/Y= ? FV=1,000 PMT= 107 (1,000x0.1070) PV= -1,161.06

The Timberlake-Jackson Wardrobe Co. has 10.7 percent coupon bonds on the market with eleven years left to maturity. The bonds make annual payments and have a par value of $1,000. If the bonds currently sell for $1,161.06, what is the YTM?

- treasury bonds - treasury notes

The U.S. government borrows money by issuing?

the bond's face value or par value.

The amount that will be repaid at the end of the loan is called?

The coupon rate on the bond Ex: $120/1,000 = 12%, the bond has a 12 percent coupon rate.

The annual coupon divided by the face value is called?

- The basic terms of the bonds. - The total amount of bonds issued. - A description of property used as security. - The repayment arrangements. - The call provisions. - Details of the protective covenants.

The bond indenture is a legal document. It can run several hundred pages and generally makes for very tedious reading. It is an important document, however, because it generally includes the following provisions:

(1 + R ) = (1 + r) x (1+h)

The model that correctly specifies the relationship between the nominal rate and the real rate is: R = the nominal rate r = the real rate

the bond's time to maturity. A corporate bond will frequently have a maturity of 30 years when it is originally issued, but this varies.

The number of years until the face value is paid is called?

protect bondholders from issuer actions.

The primary purpose of protective covenants is to help:

The term structure of interest rates.

The relationship between short- and long-term interest rates?

Interest rate risk

The risk that arises for bond owners from fluctuating interest rates is called?

- the pure TVM - the relationship between nomial rates and time to maturity

The term structure of interest rates describes?

I, II, and IV - interest rate risk premium - real rate of interest - inflation premium

The term structure of interest rates is primarily based on which three of the following? I. Interest rate risk premium II. Real rate of interest III. Default risk premium IV. Inflation premium V. Liquidity premium

what nominal interest rates are on default-free, pure discount bonds of all maturities. These rates are, in essence, "pure" interest rates because they involve no risk of default and a single, lump-sum future payment. In other words, the term structure tells us the pure time value of money for different lengths of time.

The term structure of interest rates tell us

- the number of periods remaining until maturity - the face value (par vlaue) - the coupon rate - and the market interest rate for bonds with similar features.

To determine the value of a bond at a particular point in time we need to know:

Increases.

When interest rates in the market fall, bond values will increase because the PV of the bond's remaining cash flows ______.

decrease

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

- an interest-only loan (meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan). - they are issued by both goverments and corportations

Which of the following are true of bonds?

Equity is publicly traded while debt is not

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

- Liquidity premium - Default risk premium

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

- Upward sloping - Humped - Downward sloping

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

Senior

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

$1,065.28

You invest in a bond paying 6% interest paid semiannually with a face value of $1,000. The bond matures in 8 years and similar yield 5%. What is the current vaule of the bond?

- the total amount of bonds issued - the repayment arrangements

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

Market interest rate fluctuations

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