FIN 320: Chapter Seven (Bonds and Their Valuation)

Now, consider the situation in which Sophia wants to earn a return of 8.50%, but the bond being considered for purchase offers a coupon rate of 10.50%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of ___ (rounded to the nearest whole dollar) is ___ its par value, so that the bond is ___ .

$1,052 / greater than / trading at a premium

Assume that a $1,000,000 par value, semiannual coupon US Treasury note with five years to maturity has a coupon rate of 3%. The yield to maturity (YTM) of the bond is 8.80%. Using this information and ignoring the other costs involved, calculate the value of the Treasury note:

$769,398.74 = $15,000[PVIFA 4.40%, 10 Years] + $10,00,000[PVIF 4.40%, 10 Years] = [$15,000 x 7.95176760] + [$10,00,000 x 0.65012223]

Now, consider the situation in which Ella wants to earn a return of 11%, but the bond being considered for purchase offers a coupon rate of 8.00%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of ___ (rounded to the nearest whole dollar) is ___ its par value, so that the bond is ___ .

$925 (=PV(Required Rate/Life*2, -Bond semiannual payment, -Bonds per value) less than / trading at a discount

Now, consider the situation in which Liam wants to earn a return of 17%, but the bond being considered for purchase offers a coupon rate of 14.00%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of ___ (rounded to the nearest whole dollar) is ____ its par value, so that the bond is ___ .

$932 / less than / trading at a discount

In July 2009, Walmart sold 100 billion yen of five-year samurai bonds. Lead managers in the deal were Mizuho Securities, BNP Paribas, and Mitsubishi UFJ Securities. 1. Who is the issuer of the bonds? 2. What type of bonds are these?

1. Walmart 2. Corporate bonds

If Chapman Inc. wants to issue new 30-year bonds today, what coupon rate would the bonds have to pay to be issued at par?

10.15%

If Chapman Inc. wants to issue new 30-year bonds today, what coupon rate would the bonds have to pay to be issued at par?

12.05%

If interest rates are expected to remain constant, what is the best estimate of the remaining life left for BTR Co.'s bonds?

18 years

Bridge Bonds Series A Dated 7-15-2005 4.375% Due 7-15-2055 @100.00 What is the coupon interest rate of this bond?

4.375%

When valuing a semiannual coupon bond, the time period variable(N) used to calculate the price of a bond reflects the number of ___ periods remaining in the bond's life.

6-month

f you were to calculate the yield on a security with a 10-year US Treasury security, the yield will be equal to ___.

6.20%

If Blanche Inc. issued new bonds today, what coupon rate must the bonds have to be issued at par?

7.93%

If interest rates are expected to remain constant, what is the best estimate of the remaining life left for Blanche Inc.'s bonds?

8 years

If BTR Co. issued new bonds today, what coupon rate must the bonds have to be issued at par?

8.24%

The following graph shows the relationship between interest rates and maturity for three security classes: US Treasury securities (USTs), AA-rated corporate bonds, and BBB-rated corporate bonds. Use the selection dropdown lists to correctly associate each curve with its corresponding security class:

A = BBB B = AA C = UST

For example, assume Ella wants to earn a return of 8.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 8.00% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value:

A: Bond's semiannual coupon payment | $40.00 B: Bond's par value | $1,000 C: Semiannual required return | 4.0000%

For example, assume Sophia wants to earn a return of 12.25% and is offered the opportunity to purchase a $1,000 par value bond that pays a 10.50% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value:

A: Bond's semiannual coupon payment | $52.50 B: Bond's par value | $1,000 C: Semiannual required return | 6.1250%

For example, assume Liam wants to earn a return of 8.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 14.00% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value:

A: Bond's semiannual coupon payment | $70.00 B: Bond's par value | $1,000 C: Semiannual required return | 4.0000%

Which bond is trading at a premium?

Acme Inc.

Which type of bonds offer a higher yield?

Callable bonds

Irwin, LLC = 6% Johnson Corporation = 12% Smith Incorporated = 9%

Curve A = Johnson Corporation Curve B = Smith Incorporated Curve C = Irwin, LLC

Johnson Incorporated = 6% Smith, LLC = 12% Irwin Corporation = 9%

Curve A = Smith, LLC Curve B = Irwin Corporation Curve C = Johnson Incorporated

These bonds are traded in the bond markets based on investors' belief that the issuer will not default on the repayment. These bonds have no collateral and usually offer higher yields.

Debentures

True or False: Assuming all else is equal, the shorter a bond's maturity, the more its price will change in response to a given change in interest rates.

False

Consider the case of an investor, Nazim: Nazim wants to include putable bonds in his investment portfolio. Nazim is likely to put the bonds when:

He has reinvestment options with higher yields.

Stay Corp. | Niagular Corp. | Acme Inc. | Ashpool Inc. | Kumatsu Co.

Kumatsu Co. Last Price = $90.98

In January 2009, American electronics retailer Circuit City Inc. closed all of its stores and sold all of its merchandise. This is an example of:

Liquidation

Which bond is trading at a premium?

Murphy & Co.

Which bond is trading at a premium?

Murphy and Co.

As the name suggests, convertible bonds allow the owner the option to convert the bonds into a fixed number of shares of common stock. Which of the following are most likely to have higher yields?

Nonconvertible bonds

Schubert Inc | Chapman Inc. | Rust Inc. | Murphy & Co. | Pickman Inc.

Pickman Inc. Last Yield = 8.56%

Schubert Inc | Chapman Inc. | Rust Inc. | Murphy & Co. | Pickman Inc.

Pickman Inc. Last Yield = 8.80%

These bonds are backed by real estate holdings and equipment, and if a company goes bankrupt, the collateral can be sold off to compensate for the default. These bonds, more so than other collateralized securities, have prior claims over assets.

Senior mortgage bonds

These bonds are considered the riskiest of all corporate bonds and thus offer the highest interest rates.

Subordinated debentures

Based on the graph, which of the following statements is true? The 1-year bond has more interest rate risk. Both bonds have equal interest rate risk. The 10-year bond has more interest rate risk. Neither bond has any interest rate risk.

The 10-year bond has more interest rate risk.

Yield to maturity (YTM) is the rate of return expected from a bond held until its maturity date. However, the YTM equals the expected rate of return under certain assumptions. Which of the following is one of those assumptions?

The bond will not be called.

Based on the preceding information, which of the following statements are true? Check all that apply. The bonds have the same expected total return. The expected capital gains yield for Smith, LLC's bonds is greater than 12%. The expected capital gains yield for Smith, LLC's bonds is negative. Johnson Incorporated's bonds have the highest expected total return.

The bonds have the same expected total return. The expected capital gains yield for Smith, LLC's bonds is negative.

Based on the preceding information, which of the following statements are true? Check all that apply. The current yield for Johnson Corporation's bonds is between 0% and 9%. The current yield for Johnson Corporation's bonds is greater than 9%. Johnson Corporation's bonds have the highest expected total return. Smith Incorporated's bonds are selling at par.

The current yield for Johnson Corporation's bonds is greater than 9%. Smith Incorporated's bonds are selling at par.

Yield to maturity (YTM) is the rate of return expected from a bond held until its maturity date. However, the YTM equals the expected rate of return under certain assumptions. Which of the following is one of those assumptions?

The probability of default is zero.

Which of the following statements about Treasury bonds is the most accurate? Treasury bonds have a very small amount of default risk, so they are not completely riskless. Treasury bonds are completely riskless. Treasury bonds are not completely riskless, since their prices will decline when interest rates rise.

Treasury bonds are not completely riskless, since their prices will decline when interest rates rise.

True or False: Assuming all else is equal, long-term securities are exposed to higher interest rate risk than short-term securities.

True

Based on your understanding of bond ratings and bond-rating criteria, which of the following statements is true?

US government bonds usually have the lowest yields in the bond markets.

Issuers can gradually reduce the outstanding balance of a bond issue by using a sinking fund account into which they deposit a specified amount of money each year. To operationalize the sinking fund provision of an indenture, issuers can (1) purchase a portion of the debt in the open market or (2) call the bonds if they contain a call provision. Under what circumstances would a firm be more likely to buy the required number of bonds in the open market as opposed to using one of the other procedures?

When interest rates are higher than they were when the bonds were issued

Given your computation and conclusions, which of the following statements is true? When the coupon rate is greater than Sophia's required return, the bond should trade at a premium. A bond should trade at a par when the coupon rate is greater than Sophia's required return. When the coupon rate is greater than Sophia's required return, the bond's intrinsic value will be less than its par value. When the coupon rate is greater than Sophia's required return, the bond should trade at a discount.

When the coupon rate is greater than Sophia's required return, the bond should trade at a premium.

Given your computation and conclusions, which of the following statements is true? When the coupon rate is less than Liam's required return, the bond should trade at a discount. When the coupon rate is less than Liam's required return, the bond should trade at a premium. When the coupon rate is less than Liam's required return, the intrinsic value will be greater than its par value. A bond should trade at par when the coupon rate is less than Liam's required return.

When the coupon rate is less than Liam's required return, the bond should trade at a discount.

Blanche Inc. has 9% annual coupon bonds that are callable and have 18 years left until maturity. The bonds have a par value of $1,000, and their current market price is $1,100.35. However, Blanche Inc. may call the bonds in eight years at a call price of $1,060. What are the YTM and the yield to call (YTC) on Blanche Inc.'s bonds?

YTM = 7.93% | YTC = 7.83%

BTR Co. has 9% annual coupon bonds that are callable and have 18 years left until maturity. The bonds have a par value of $1,000, and their current market price is $1,070.35. However, BTR Co. may call the bonds in eight years at a call price of $1,060. What are the YTM and the yield to call (YTC) on BTR Co.'s bonds?

YTM = 8.24% (Life, Coupon, PV, FV) YTC = 8.32% (Callable, Coupon, PV, Call Price)

When the bond's coupon rate is less than the bondholder's required return, the bond's intrinsic value will be less than its par value, and the bond will trade at ____ .

a discount

The contract that describes the terms of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds is called ___.

an indenture

If a bond is selling for a price much lower than its par value, it is most likely that the bond is ___ bond.

an outstanding

A bond's ___ gives the issuer the right to call, or redeem, a bond at specific times and under specific conditions.

call provision

A bond's ___ refers to the interest payment or payments paid by a bond.

coupon payment

A bond issuer is said to be in ___ if it does not pay the interest or the principal in accordance with the terms of the indenture agreement or if it violates one or more of the issue's restrictive covenants.

default

When the bond's coupon rate is greater than the bondholder's required return, the bond's intrinsic value will ___ its par value, and the bond will trade at a premium.

exceed

If the coupon interest rate remains constant from the time of issue until the bond matures, then the bond is called a ___ bond.

fixed-rate

Frank Barlowe is retiring soon, so he's concerned about his investments providing him with a steady income every year. He's aware that if interest rates ___ , the potential earnings power of the cash flow from his investments will increase. In particular, he is concerned that a decline in interest rates might lead to ___ annual income from his investments. What kind of risk is Frank most concerned about protecting against?

increase / less / Reinvestment risk

The contract that describes the terms of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds is called the ___ .

indenture

Nazim also recently bought bonds that have their interest rate tied to the consumer price index (CPI) so that he will be protected if inflation rates increase. Nazim has invested in ___ .

indexed bonds

Based on this equation and the data, it is ___ to expect that Ella's potential bond investment is currently exhibiting an intrinsic value equal to $1,000.

reasonable

Based on this equation and the data, it is ____ to expect that Liam's potential bond investment is currently exhibiting an intrinsic value greater than $1,000.

reasonable

Smith Incorporated's bonds have exhibited a substantial trading volume in the past few years. Its bonds would be referred to as a ___ .

seasoned issue

Based on this equation and the data, it is ____ to expect that Sophia's potential bond investment is currently exhibiting an intrinsic value greater than $1,000.

unreasonable

Remember, a bond's coupon rate partially determines the interest-based return that a bond ___ pay, and a bondholder's required return reflects the return that a bondholder ___ to receive from a given investment.

will / would like