Finance Test 2
Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, 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
Which of the following bonds would have the greatest percentage increase in value if all interest rates in the economy fall by 1%?
20-year, zero coupon bond.
Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price?
A 10-year zero coupon bond.
If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value?
A 10-year zero coupon bond.
Which of the following bonds has the greatest price risk?
A 10-year, $1,000 face value, zero coupon bond.
Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?
A bank loan's nominal interest rate will always be equal to or less than its effective annual rate.
Which of the following statements is CORRECT?
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.
Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT?
A larger proportion of the first monthly payment will be interest, and a smaller proportion will be principal, than for the last monthly payment.
You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT?
A rational investor would be willing to pay more for DUE than for ORD, so their market prices should differ.
Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT?
A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment.
Under normal conditions, which of the following would be most likely to increase the coupon rate required for a bond to be issued at par?
Adding a call provision.
Which of the following statements is CORRECT?
All else equal, bonds with larger coupons have less price risk than bonds with smaller coupons.
Which of the following statements is CORRECT?
All else equal, if a bond's yield to maturity increases, its price will fall.
Which of the following statements is CORRECT?
All else equal, senior debt generally has a lower yield to maturity than subordinated debt.
Which of the following statements is CORRECT?
All else equal, short-term bonds have less reinvestment risk than long-term bonds.
Which of the following bank accounts has the lowest effective annual return?
An account that pays 7% nominal interest with monthly compounding.
Which of the following bank accounts has the highest effective annual return?
An account that pays 8% nominal interest with daily (365-day) compounding.
You plan to invest some money in a bank account. Which of the following banks provides you with the highest effective rate of interest?
Bank 5; 6.0% with daily (365-day) compounding.
Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.)
Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant.
Three $1,000 face value, 10-year, noncallable, bonds have the same amount of risk, hence their YTMs are equal. Bond 8 has an 8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12 has a 12% annual coupon. Bond 10 sells at par. Assuming that interest rates remain constant for the next 10 years, which of the following statements is CORRECT?
Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year.
Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon. Both bonds have the same maturity, a face value of $1,000, an 8% yield to maturity, and are noncallable. Which of the following statements is CORRECT?
Bond A's current yield is greater than that of Bond B.
A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Neither is callable, and both have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be CORRECT?
Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.
Which of the following statements is CORRECT?
Convertible bonds generally have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains.
Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows: T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were most probably caused primarily by:
Default and liquidity risk differences.
Which of the following statements is CORRECT?
Even if a bond's YTC exceeds its YTM, an investor with an investment horizon longer than the bond's maturity would be worse off if the bond were called.
A bond that had a 20-year original maturity with 1 year left to maturity has more price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.)
False
A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond.
False
A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline.
False
A time line is not meaningful unless all cash flows occur annually.
False
A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at par. These bonds provide compensation to investors in the form of capital appreciation.
False
All other things held constant, the present value of a given annual annuity increases as the number of periods per year increases.
False
As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or less than the nominal rate on the deposit (or loan).
False
Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more price risk if you purchased a 30-day bond than if you bought a 30-year bond.
False
Disregarding risk, if money has time value, it is impossible for the future value of a given sum to exceed its present value.
False
Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floating-rate debt shifts price risk to companies, it offers no advantages to corporate issuers.
False
If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate.
False
If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series.
False
If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year.
False
Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds.
False
Midway through the life of an amortized loan, the percentage of the payment that represents interest must be equal to the percentage that represents repayment of principal. This is true regardless of the original life of the loan or the interest rate on the loan.
False
Some of the cash flows shown on a time line can be in the form of annuity payments but none can be uneven amounts.
False
Starting to invest early for retirement reduces the benefits of compound interest.
False
Suppose Randy Jones plans to invest $1,000. He can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be somewhat less than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.)
False
The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the greater the present value of a given lump sum to be received at some future date.
False
The payment made each period on an amortized loan is constant, and it consists of some interest and some principal. The closer we are to the end of the loan's life, the smaller the percentage of the payment that will be a repayment of principal.
False
The present value of a future sum increases as either the discount rate or the number of periods per year increases, other things held constant.
False
Time lines cannot be constructed for annuities unless all the payments occur at the end of the periods.
False
Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly.
False
When a loan is amortized, a relatively high percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage declines in the loan's later years.
False
You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment-grade rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both are offered to you at their $1,000 par values. However, Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF.
False
Assuming all else is constant, which of the following statements is CORRECT?
For a bond of any maturity, a 1.0 percentage point increase in the market interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from a 1.0 percentage point decrease in the interest rate.
Which of the following statements is CORRECT?
If CF0 is positive and all the other CFs are negative, then you can still solve for I.
Which of the following statements is CORRECT?
If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value.
Which of the following statements is CORRECT?
If a bond's yield to maturity exceeds its coupon rate, the bond's price must be less than its maturity value.
Which of the following statements is CORRECT?
If a coupon bond is selling at par, its current yield equals its yield to maturity, and its expected capital gains yield is zero.
Which of the following statements is CORRECT?
If a coupon bond is selling at par, its current yield equals its yield to maturity.
Which of the following statements is CORRECT?
If a loan has a nominal annual rate of 8%, then the effective rate will never be less than 8%.
Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?
If an investment pays 10% interest, compounded quarterly, its effective annual rate will be greater than 10%.
A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT?
If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds.
Assume that a noncallable 10-year T-bond has a 12% annual coupon, while a 15-year noncallable T-bond has an 8% annual coupon. Assume also that the yield curve is flat, and all Treasury securities have 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.
A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT?
If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.
Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Each of the bonds is noncallable, has a maturity of 10 years, and has a yield to maturity of 10%. Which of the following statements is CORRECT?
If the bonds' market interest rate remains at 10%, Bond Z's price will be lower one year from now than it is today.
Bonds A, B, and C all have a maturity of 10 years and a yield to maturity of 7%. Bond A's price exceeds its par value, Bond B's price equals its par value, and Bond C's price is less than its par value. None of the bonds can be called. Which of the following statements is CORRECT?
If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.
A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following statements is CORRECT?
If the yield to maturity remains at 8%, then the bond's price will decline over the next year.
A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT?
If the yield to maturity remains constant, the bond's price one year from now will be lower than its current price.
A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following statements is CORRECT?
If the yield to maturity remains constant, the price of the bond will decline over time.
Which of the following statements is CORRECT?
If their maturities and other characteristics were the same, a 5% coupon bond would have more price risk than a 10% coupon bond.
Suppose a new company decides to raise a total of $200 million, with $100 million as common equity and $100 million as long-term debt. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT?
In this situation, we cannot tell for sure how, or even whether, the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each type of bond would increase as the percentage of mortgage bonds used was increased, but the average cost might well be such that the firm's total interest charges would not be affected materially by the mix between the two.
Which of the following statements is CORRECT?
Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds.
Which of the following investments would have the highest future value at the end of 10 years? Assume that the effective annual rate for all investments is the same and is greater than zero.
Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).
Which of the following investments would have the lowest present value? Assume that the effective annual rate for all investments is the same and is greater than zero.
Investment D pays $2,500 at the end of 10 years (just one payment).
Which of the following events would make it more likely that a company would call its outstanding callable bonds?
Market interest rates decline sharply.
An investor is considering buying one of two 10-year, $1,000 face value, noncallable bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, and the YTM is expected to remain constant for the next 10 years. Which of the following statements is CORRECT?
One year from now, Bond A's price will be higher than it is today.
Which of the following statements is CORRECT?
Reinvestment risk is lower, other things held constant, on long-term than on short-term bonds.
Which of the following statements is CORRECT?
Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more price risk but less reinvestment risk.
Which of the following statements 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 U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT?
The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity.
A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT?
The bond's expected capital gains yield is zero.
A 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT?
The bond's yield to maturity is greater than its coupon rate.
Which of the following statements is CORRECT?
The cash flows for an annuity due must all occur at the beginning of the periods.
Which of the following statements is CORRECT?
The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month.
Amram 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. Alternatively, Amram 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 Amram 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 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%.
You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would increase the calculated value of the investment?
The discount rate decreases.
You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?
The discount rate increases.
Which of the following statements is CORRECT?
The market price of a bond will always approach its par value as its maturity date approaches, provided the bond's required return remains constant.
Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.)
The outstanding balance declines at a faster rate in the later years of the loan's life.
Your bank account pays a 6% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT?
The periodic rate of interest is 1.5% and the effective rate of interest is greater than 6%.
Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT?
The periodic rate of interest is 2% and the effective rate of interest is greater than 8%.
You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT?
The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD.
Which of the following statements is CORRECT?
The present value of a 3-year, $150 annuity due will exceed the present value of a 3-year, $150 ordinary annuity.
A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT?
The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually.
You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT?
The price of Bond A will decrease over time, but the price of Bond B will increase over time.
Which of the following statements is CORRECT?
The price of a discount bond will increase over time, assuming that the bond's yield to maturity remains constant.
A $50,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these statements is CORRECT?
The proportion of each payment that represents interest as opposed to repayment of principal would be lower if the interest rate were lower.
A $150,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these statements is CORRECT?
The proportion of each payment that represents interest versus repayment of principal would be higher if the interest rate were higher.
Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their required rate of return?
The required rate of return would increase because the bond would then be more risky to a bondholder.
Which of the following statements is CORRECT?
The total (rate of) return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year, divided by the bond's price at the beginning of the year.
Which of the following statements is CORRECT?
The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield.
Which of the following statements is CORRECT?
Time lines are useful for visualizing complex problems prior to doing actual calculations.
Which of the following statements is CORRECT?
Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods.
Which of the following statements is CORRECT?
Time lines can be constructed to deal with situations where some of the cash flows occur annually but others occur quarterly.
Which of the following statements is CORRECT?
Time lines can be constructed where some of the payments constitute an annuity but others are unequal and thus are not part of the annuity.
Which of the following statements is CORRECT?
To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the PV of the negative CFs. This is, essentially, a trial-and-error procedure that is easy with a computer or financial calculator but quite difficult otherwise.
A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if market interest rates are below 10% and at a discount if interest rates are greater than 10%.
True
A time line is meaningful even if all cash flows do not occur annually.
True
All other things held constant, the present value of a given annual annuity decreases as the number of periods per year increases.
True
As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured.
True
As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or greater than the nominal rate on the deposit (or loan).
True
Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value.
True
If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate.
True
If a firm raises capital by selling new bonds, it could be called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.
True
If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series.
True
If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.)
True
If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by multiplying the periodic rate by the number of periods per year.
True
Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength.
True
Midway through the life of an amortized loan, the percentage of the payment that represents interest could be equal to, less than, or greater than to the percentage that represents repayment of principal. The proportions depend on the original life of the loan and the interest rate.
True
Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.
True
Restrictive covenants are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures.
True
Sinking funds are provisions included in bond indentures that 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
Some of the cash flows shown on a time line can be in the form of annuity payments while others can be uneven amounts.
True
Starting to invest early for retirement increases the benefits of compound interest.
True
Suppose Sally Smith plans to invest $1,000. She can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be more than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.)
True
The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.
True
The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the smaller the present value of a given lump sum to be received at some future date.
True
The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.
True
The payment made each period on an amortized loan is constant, and it consists of some interest and some principal. The closer we are to the end of the loan's life, the greater the percentage of the payment that will be a repayment of principal.
True
The present value of a future sum decreases as either the discount rate or the number of periods per year increases, other things held constant.
True
The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity.
True
The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant.
True
There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower.
True
Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods.
True
Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly.
True
When a loan is amortized, a relatively low percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage increases in the loan's later years.
True
You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%.
True
Which of the following statements is CORRECT?
Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.
Which of the following statements is CORRECT?
Under Chapter 11 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 Act.
Which of the following statements is CORRECT?
You hold two bonds, a 10-year, zero coupon, issue and a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon bond will experience the larger percentage decline.