Essentials of Financial Management Third Edition
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CHAPTER 9 BONDS AND THEIR VALUATION
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.
Multiple Choice: True/False
(9-2) Coupon rate
F G
Answer: a EASY
1. 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.
a. True
b. False
(9-2) Call provision
F G Answer: b EASY
2. 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.
a. True
b. False
(9-2) Sinking fund
F G
Answer: a EASY
3. 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.
a. True
b. False
(9-2) Zero coupon bond
F G
Answer: b EASY
4 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.
a. True
b. False
True/False
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(9-2) Floating-rate debt
F G
Answer: a EASY
5. 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.
a. True
b. False
(9-3) Discounted cash flows
F G
Answer: a EASY
6 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.
a. True
b. False
(9-5) Bond prices and int. rates
F G
Answer: a EASY
7 The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity
a. True
b. False
(9-7) Price risk
F G
Answer: b EASY
8 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.)
a. True
b. False
(9-7) Price risk
F G
Answer: b EASY
9 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.
a. True
b. False (9-8) Bonds and debentures
F G
Answer: a EASY
10 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.
a. True
b. False
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(9-8) Junk bond
F G
Answer: a EASY
11. 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.
a. True
b. False
(9-8) Bond ratings & req. returns
F G
Answer: a EASY
12. 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.
a. True
b. False
(9-2) Income bond
F G
Answer: b MEDIUM
13. 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.
a. True
b. False
(9-2) Sinking fund
F G
Answer: b MEDIUM
14. 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.
a. True
b. False
(9-2) Floating-rate debt
F G
Answer: b MEDIUM
15 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.
a. True
b. False
(9-3) Bond premiums and discounts
F G
Answer: a MEDIUM
16. 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
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are below 10% and at a discount if interest rates are greater than 10%.
a. True
b. False
(9-3) Bond value annual payment
F G
Answer: a MEDIUM
17. 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%.
a. True
b. False
(9-5) Bond prices and returns
F G
Answer: a MEDIUM
18. 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.)
a. True
b. False
(9-5) Prices and interest rates
F G
Answer: a MEDIUM
19. 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.
a. True
b. False
(9-8) Restrictive covenants
F G
Answer: a MEDIUM
20. Restrictive covenants are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures.
a. True
b. False
(9-8) Bonds and debentures
F G
Answer: a MEDIUM
21. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.
a. True
b. False
(9-4) Callable bonds
F G
Answer: b HARD
22. 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.
a. True
b. False
Multiple Choice: Conceptual
Most of these questions can be answered by thinking about relationships and reasoning out which answer is correct, but some require students to do a few calculations. Even if logical answers can be determined, it may be useful to confirm them by working out some numbers. Sometimes data are provided in the question, but sometimes students must make up their own examples to take the numerical approach.
Most students will have to think carefully to answer the MEDIUM and HARD questions, and that will take some time. Therefore, the more time they have to do the test or quiz, the better their scores should be.
Some of the questions are focused on a particular section, but others have statements that are covered in various sections. In the latter case, we indicate “Comprehensive” rather than give a section number.
Finally, note that we provide answers only to selected questions. We see no need to answer relatively easy, obvious questions, so we limit answers to questions where students might have trouble understanding why their answer is wrong.
(9-5) Interest rates
C G
23. Which of the following statements is CORRECT?
Answer: a EASY
a. 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.
b. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates.
c. You hold two bonds. One is a 10-year, zero coupon, bond and the other is 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 the current level, the zero coupon bond will experience the smaller percentage decline.
d. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates, other things held constant.
e. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates.
(9-7) Calling bonds
C G Answer: c EASY
24. Which of the following events would make it more likely that a company would call its outstanding callable bonds?
a. The company’s bonds are downgraded.
b. Market interest rates rise sharply.
c. Market interest rates decline sharply.
d. The company's financial situation deteriorates significantly.
e. Inflation increases significantly.
(9-8) Bond ratings
C G
Answer: c EASY
25. 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%
AAA = 8.72%
A = 9.64%
BBB = 10.18%
The differences in rates among these issues were most probably caused primarily by:
a. Real risk-free rate differences.
b. Tax effects.
c. Default and liquidity risk differences.
d. Maturity risk differences.
e. Inflation differences
(9-2) Bond coupon rate
C G
Answer: b MEDIUM
26. 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?
a. Adding additional restrictive covenants that limit management's actions.
b. Adding a call provision.
c. The rating agencies change the bond's rating from Baa to Aaa.
d. Making the bond a first mortgage bond rather than a debenture.
e. Adding a sinking fund.
(9-2) Sinking funds
C G
27. Which of the following statements is CORRECT?
Answer: a MEDIUM
a. 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.
b. 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.
c. A sinking fund provision makes a bond more risky to investors at the time of issuance.
d. Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time.
e. 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.
(9-2) Convertible, callable bonds
C G
Answer: b MEDIUM
28. 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?
a. The coupon rate should be exactly equal to 6%.
b. 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%.
c. The rate should be slightly greater than 6%.
d. The rate should be over 7%.
e. The rate should be over 8%.
(9-4)
Bond yields
C G
Answer: d MEDIUM
29 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?
a. Because of the call premium, the required rate of return would decline.
b. There is no reason to expect a change in the required rate of return.
c. The required rate of return would decline because the bond would then be less risky to a bondholder.
d. The required rate of return would increase because the bond would then be more risky to a bondholder.
e. It is impossible to say without more information.
(9-4)
Bond yields
C G
Answer: a MEDIUM
30. 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?
a. The bond’s expected capital gains yield is zero.
b. The bond’s yield to maturity is above 9%.
c. The bond’s current yield is above 9%.
d. If the bond’s yield to maturity declines, the bond will sell at a discount.
e. The bond’s current yield is less than its expected capital gains yield.
(9-4) Bond yields
C G
31. Which of the following statements is CORRECT?
Answer: c MEDIUM
a. A zero coupon bond's current yield is equal to its yield to maturity.
b. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at par.
c. All else equal, if a bond’s yield to maturity increases, its price will fall.
d. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at a premium over par.
e. All else equal, if a bond’s yield to maturity increases, its current yield will fall.
(9-4) Bond yields
C G
Answer: c MEDIUM
32. A 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT?
a. The bond’s coupon rate exceeds its current yield.
b. The bond’s current yield exceeds its yield to maturity.
c. The bond’s yield to maturity is greater than its coupon rate.
d. The bond’s current yield is equal to its coupon rate.
e. If the yield to maturity stays constant until the bond matures, the bond’s price will remain at $850.
(9-4) Bond yields
C G
33 Which of the following statements is CORRECT?
Answer: d MEDIUM
a. If a bond is selling at a discount, the yield to call is a better measure of return than is the yield to maturity.
b. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss.
c. On an expected yield basis, the expected current yield will always be positive because an investor would not purchase a bond that is not expected to pay any cash coupon interest.
d. If a coupon bond is selling at par, its current yield equals its yield to maturity, and its expected capital gains yield is zero.
e. The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B.
(9-5) Bond values over time
C G
Answer: d MEDIUM
34 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?
a. Bond 8’s current yield will increase each year.
b. Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity.
c. Bond 12 sells at a premium (its price is greater than par), and its price is expected to increase over the next year.
d. Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year.
e. Over the next year, Bond 8’s price is expected to decrease, Bond 10’s price is expected to stay the same, and Bond 12’s price is expected to increase.
(9-5) Int. rates and bond prices
C G
Answer: b MEDIUM
35. 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?
a. The bond’s current yield is less than 8%.
b. If the yield to maturity remains at 8%, then the bond’s price will decline over the next year.
c. The bond’s coupon rate is less than 8%.
d. If the yield to maturity increases, then the bond’s price will increase.
e. If the yield to maturity remains at 8%, then the bond’s price will remain constant over the next year.
(9-5) Int rates and bond prices
C G
Answer: c MEDIUM
36. 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?
a. If market interest rates decline, the price of the bond will also decline.
b. The bond is currently selling at a price below its par value.
c. If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today.
d. The bond should currently be selling at its par value.
e. If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.
(9-5) Int. rates and bond prices
C G
Answer: b MEDIUM
37. 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?
a. The prices of both bonds will decrease by the same amount.
b. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.
c. The prices of both bonds would increase by the same amount.
d. One bond's price would increase, while the other bond’s price would decrease.
e. The prices of the two bonds would remain constant.
(9-5) Bond yields and prices
C G
Answer: c MEDIUM
38. 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?
a. The price of Bond B will decrease over time, but the price of Bond A will increase over time.
b. The prices of both bonds will remain unchanged.
c. The price of Bond A will decrease over time, but the price of Bond B will increase over time.
d. The prices of both bonds will increase by 7% per year.
e. The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.
(9-7) Price risk
C G
Answer: e MEDIUM
39. Which of the following bonds would have the greatest percentage increase in value if all interest rates in the economy fall by 1%?
a. 10-year, zero coupon bond.
b. 20-year, 10% coupon bond.
c. 20-year, 5% coupon bond.
d. 1-year, 10% coupon bond.
e. 20-year, zero coupon bond.
(9-7) Price risk
C G
Answer: d MEDIUM
40. 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. An 8-year bond with a 9% coupon.
b. A 1-year bond with a 15% coupon
c. A 3-year bond with a 10% coupon.
d. A 10-year zero coupon bond.
e. A 10-year bond with a 10% coupon.
(9-7) Price risk
C G
Answer: b MEDIUM
41 Which of the following bonds has the greatest price risk?
a. A 10-year $100 annuity.
b. A 10-year, $1,000 face value, zero coupon bond.
c. A 10-year, $1,000 face value, 10% coupon bond with annual interest payments.
d. All 10-year bonds have the same price risk since they have the same maturity.
e. A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.
(9-7) Price risk
C G
Answer: e MEDIUM
42. If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value?
a. A 1-year zero coupon bond.
b. A 1-year bond with an 8% coupon.
c. A 10-year bond with an 8% coupon.
d. A 10-year bond with a 12% coupon.
e. A 10-year zero coupon bond.
(9-7) Price vs. reinvest. risk
C G
43 Which of the following statements is CORRECT?
Answer: e MEDIUM
a. All else equal, high-coupon bonds have less reinvestment risk than low-coupon bonds.
b. All else equal, long-term bonds have less price risk than short-term bonds.
c. All else equal, low-coupon bonds have less price risk than highcoupon bonds.
d. All else equal, short-term bonds have less reinvestment risk than long-term bonds.
e. All else equal, long-term bonds have less reinvestment risk than short-term bonds.
(9-7) Price vs. reinvest. risk
C G
44. Which of the following statements is CORRECT?
Answer: d MEDIUM
a. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold.
b. Long-term bonds have less price risk but more reinvestment risk than short-term bonds.
c. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less price risk.
d. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more price risk but less reinvestment risk.
e. Long-term bonds have less price risk and also less reinvestment risk than short-term bonds.
(Comp.) Term structure
C G H
45. Which of the following statements is CORRECT?
Answer: e MEDIUM
a. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.
b. Liquidity premiums are generally higher on Treasury than corporate bonds.
c. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.
d. Default risk premiums are generally lower on corporate than on Treasury bonds.
e. Reinvestment risk is lower, other things held constant, on long-term than on short-term bonds.
(Comp.) Bonds & default
risk
C G
46 Which of the following statements is CORRECT?
Answer: a MEDIUM
a. All else equal, senior debt generally has a lower yield to maturity than subordinated debt.
b. An indenture is a bond that is less risky than a mortgage bond.
c. The expected return on a corporate bond will generally exceed the bond's yield to maturity.
d. If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors will also exceed its yield to maturity.
e. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.
(Comp.)
Bond concepts
C G
47 Which of the following statements is CORRECT?
Answer: a MEDIUM
a. If a coupon bond is selling at par, its current yield equals its yield to maturity.
b. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.
c. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.
d. If a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a premium.
e. If a coupon bond is selling at a premium, its current yield equals its yield to maturity.
(Comp.) Bond concepts
C G
Answer: d MEDIUM
48. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT?
a. If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price.
b. The bond is selling below its par value.
c. The bond is selling at a discount.
d. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price.
e. The bond’s current yield is greater than 9%.
(Comp.) Bond concepts
C G Answer: e MEDIUM
49. A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following statements is CORRECT?
a. The bond sells at a price below par.
b. The bond has a current yield greater than 8%.
c. The bond sells at a discount.
d. The bond’s required rate of return is less than 7.5%.
e. If the yield to maturity remains constant, the price of the bond will decline over time.
(Comp.) Bond concepts
C G
Answer: b MEDIUM
50 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?
a. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.
b. One year from now, Bond A’s price will be higher than it is today.
c. Bond A’s current yield is greater than 8%.
d. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.
e. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.
(Comp.) Bond concepts
C G
51 Which of the following statements is CORRECT?
Answer: e MEDIUM
a. If a bond is selling at a discount to par, its current yield will be greater than its yield to maturity.
b. All else equal, bonds with longer maturities have less price risk than bonds with shorter maturities.
c. If a bond is selling at its par value, its current yield equals its capital gains yield.
d. If a bond is selling at a premium, its current yield will be less than its capital gains yield.
e. All else equal, bonds with larger coupons have less price risk than bonds with smaller coupons.
(Comp.) Bond concepts
C G
52. Which of the following statements is CORRECT?
Answer: b MEDIUM
a. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value.
b. 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.
c. Other things held constant, including the coupon rate, a corporation would rather issue noncallable bonds than callable bonds.
d. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond because it would have a shorter expected life.
e. Bonds are exposed to both reinvestment risk and price risk. Longerterm low-coupon bonds, relative to shorter-term high-coupon bonds, are generally more exposed to reinvestment risk than price risk.
(Comp.)
Bond concepts
C G
53. Which of the following statements is CORRECT?
Answer: e MEDIUM
a. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.
b. The total yield on a bond is derived from dividends plus changes in the price of the bond.
c. Bonds are generally regarded as being riskier than common stocks, and therefore bonds have higher required returns.
d. Bonds issued by larger companies always have lower yields to maturity (due to less risk) than bonds issued by smaller companies.
e. 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.
(Comp.)
Bond concepts
C G
54. Which of the following statements is CORRECT?
Answer: a MEDIUM
a. If a coupon bond is selling at par, its current yield equals its yield to maturity.
b. If rates fall after its issue, a zero coupon bond could trade at a price above its maturity (or par) value.
c. If rates fall rapidly, a zero coupon bond’s expected appreciation could become negative.
d. If a firm moves from a position of strength toward financial distress, its bonds’ yield to maturity would probably decline.
e. If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon rate.
(Comp.) Bond concepts
C G
Answer: a MEDIUM
55. 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?
a. If the bonds' market interest rate remains at 10%, Bond Z’s price will be lower one year from now than it is today.
b. Bond X has the greatest reinvestment risk.
c. If market interest rates decline, the prices of all three bonds will increase, but Z's price will have the largest percentage increase.
d. If market interest rates remain at 10%, Bond Z’s price will be 10% higher one year from today.
e. If market interest rates increase, Bond X’s price will increase, Bond Z’s price will decline, and Bond Y’s price will remain the same.
(Comp.) Bond concepts
C G
Answer: d MEDIUM
56. 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?
a. If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price.
b. Bond A has the most price risk.
c. If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain the same over the next year.
d. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.
e. Bond C sells at a premium over its par value.
(Comp.) Bond concepts
C G
57. Which of the following statements is CORRECT?
Answer: c MEDIUM
a. 10-year, zero coupon bonds have more reinvestment risk than 10-year, 10% coupon bonds.
b. A 10-year, 10% coupon bond has less reinvestment risk than a 10-year, 5% coupon bond (assuming all else equal).
c. 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.
d. The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond.
e. A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11%.
(Comp.) Bond yields
C G
58. Which of the following statements is CORRECT?
Answer: d MEDIUM
a. The yield to maturity for a coupon bond that sells at a premium consists entirely of a positive capital gains yield; it has a zero current interest yield.
b. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm has filed for bankruptcy.
c. Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices.
d. 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.
e. The expected capital gains yield on a bond will always be zero or positive because no investor would purchase a bond with an expected capital loss.
(Comp.) Bond yields
C G
59 Which of the following statements is CORRECT?
Answer: e MEDIUM
a. If a coupon bond is selling at a premium, then the bond's current yield is zero.
b. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is negative.
c. If a bond is selling at a discount, the yield to call is a better measure of the expected return than the yield to maturity.
d. The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A must have a higher yield to maturity than Bond B.
e. If a coupon bond is selling at par, its current yield equals its yield to maturity.
(Comp.) Bond yields and prices
C G
60. Which of the following statements is CORRECT?
Answer: d MEDIUM
a. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of their coupon rates.
b. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds.
c. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds.
d. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value.
e. If a bond’s yield to maturity exceeds its coupon rate, the bond’s current yield must be less than its coupon rate.
(Comp.) Bond rates and prices
C G
Answer: e MEDIUM
61. 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?
a. Bond A’s capital gains yield is greater than Bond B’s capital gains yield.
b. Bond A trades at a discount, whereas Bond B trades at a premium.
c. If the yield to maturity for both bonds remains at 8%, Bond A’s price one year from now will be higher than it is today, but Bond B’s price one year from now will be lower than it is today.
d. If the yield to maturity for both bonds immediately decreases to 6%, Bond A’s bond will have a larger percentage increase in value.
e. Bond A’s current yield is greater than that of Bond B.
(Comp.) Callable bonds
C G
62. Which of the following statements is CORRECT?
Answer: a MEDIUM
a. 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.
b. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond.
c. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used.
d. 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 above the coupon rate than if it is below the coupon rate.
e. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond.
(Comp.) Types of debt
C G
63. Which of the following statements is CORRECT?
Answer: c MEDIUM
a. Senior debt is debt that has been more recently issued, and in bankruptcy it is paid off after junior debt because the junior debt was issued first.
b. A company's subordinated debt has less default risk than its senior debt.
c. Convertible bonds generally have lower coupon rates than nonconvertible bonds of similar default risk because they offer the possibility of capital gains.
d. Junk bonds typically provide a lower yield to maturity than investment-grade bonds.
e. A debenture is a secured bond that is backed by some or all of the firm’s fixed assets.
(Comp.) Miscellaneous concepts
C G
64. Which of the following statements is CORRECT?
Answer: d MEDIUM
a. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the use of debt until the bonds mature.
b. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond.
c. Once a firm declares bankruptcy, it must be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and legal fees.
d. 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.
e. A firm with a sinking fund that gives it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate.
(Comp.) Miscellaneous concepts
C G
65 Which of the following statements is CORRECT?
Answer: c MEDIUM
a. The total return on a bond during a given year is based only on the coupon interest payments received.
b. All else equal, a bond that has a coupon rate of 10% will sell at a discount if the required return for bonds of similar risk is 8%.
c. The price of a discount bond will increase over time, assuming that the bond’s yield to maturity remains constant.
d. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds.
e. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized.
(Comp.) Default and bankruptcy C G
66. Which of the following statements is CORRECT?
Answer: e MEDIUM
a. All else equal, secured debt is more risky than unsecured debt.
b. The expected return on a corporate bond must be greater than its promised return if the probability of default is greater than zero.
c. All else equal, senior debt has more default risk than subordinated debt.
d. A company’s bond rating is affected by its financial ratios but not by provisions in its indenture.
e. 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.
(Comp.) Calling a bond C G Answer: c MEDIUM/HARD
67. Which of the following statements is CORRECT?
a. A bond is likely to be called if its coupon rate is below its YTM.
b. A bond is likely to be called if its market price is below its par value.
c. 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.
d. A bond is likely to be called if its market price is equal to its par value.
e. A bond is likely to be called if it sells at a discount below par.
(9-4) Current yield and YTM C G
68. Which of the following statements is CORRECT?
Answer: b HARD
a. 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.
b. 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.
c. If a bond sells at par, then its current yield will be less than its yield to maturity.
d. If a bond sells for less than par, then its yield to maturity is less than its coupon rate.
e. A discount bond’s price declines each year until it matures, when its value equals its par value.
(9-5) Int rates and bond prices
C G
Answer: a HARD
69. 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?
a. If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price.
b. If interest rates decline, the prices of both bonds would increase, but the 10-year bond would have a larger percentage increase in price.
c. The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium.
d. The 10-year bond would sell at a premium, while the 15-year bond would sell at par.
e. If the yield to maturity on both bonds remains at 10% over the next year, the price of the 10-year bond would increase, but the price of the 15-year bond would fall.
(9-7)
Price and reinvest risk
C G
70. Which of the following statements is CORRECT?
Answer: b HARD
a. A zero coupon bond of any maturity will have more price risk than any coupon bond, even a perpetuity.
b. If their maturities and other characteristics were the same, a 5% coupon bond would have more price risk than a 10% coupon bond.
c. A 10-year coupon bond would have more reinvestment risk than a 5year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment risk.
d. A 10-year coupon bond would have more price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of price risk.
e. If their maturities and other characteristics were the same, a 5% coupon bond would have less price risk than a 10% coupon bond.
(9-8)
Bond indenture
C G
Answer: a HARD
71. 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.
(Comp.) Costs of types of debt
C
G
Answer: c HARD
72. 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?
a. The higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be and, consequently, the higher the firm’s total dollar interest charges will be.
b. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm’s total interest expense would be lower than if the debt were raised by issuing $100 million of debentures.
c. 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.
d. The higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures.
e. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm’s total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.
(Comp.) Costs of types of debt
C G Answer: b HARD
73. A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT?
a. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future.
b. 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.
c. If two classes of debt are used (with one senior and the other subordinated to all other debt), the subordinated debt will carry a lower interest rate.
d. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond.
e. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan.
(Comp.) Bond concepts
C G
Answer: e HARD
74. Assuming all else is constant, which of the following statements is CORRECT?
a. Other things held constant, a 20-year zero coupon bond has more reinvestment risk than a 20-year coupon bond.
b. Other things held constant, for any given maturity, a 1.0 percentage point decrease in the market interest rate would cause a smaller dollar capital gain than the capital loss stemming from a 1.0 percentage point increase in the interest rate.
c. From a corporate borrower’s point of view, interest paid on bonds is not tax-deductible.
d. Other things held constant, price sensitivity as measured by the percentage change in price due to a given change in the required rate of return decreases as a bond’s maturity increases.
e. 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.
Multiple Choice: Problems
(9-3) Bond valuation: annual
C G
Answer: a EASY
75 Morin Company's bonds mature in 8 years, have a par value of $1,000, and make an annual coupon interest payment of $65. The market requires an interest rate of 8.2% on these bonds. What is the bond's price?
a. $903.04
b. $925.62
c. $948.76
d. $972.48
e. $996.79
(9-3) Bond valuation: annual
C G Answer: d EASY
76. Ryngaert Inc. recently issued noncallable bonds that mature in 15 years. They have a par value of $1,000 and an annual coupon of 5.7%. If the current market interest rate is 7.0%, at what price should the bonds sell?
a. $817.12
b. $838.07
c. $859.56
d. $881.60
e. $903.64
(9-4) Yield to maturity
C G
Answer: e EASY
77. Adams Enterprises’ noncallable bonds currently sell for $1,120. They have a 15-year maturity, an annual coupon of $85, and a par value of $1,000. What is their yield to maturity?
a. 5.84%
b. 6.15%
c. 6.47%
d. 6.81%
(9-4) Yield to maturity
C G Answer: b EASY
78. Dyl Inc.'s bonds currently sell for $1,040 and have a par value of $1,000. They pay a $65 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100. What is their yield to maturity (YTM)?
a. 5.78%
b. 6.09%
c. 6.39%
d. 6.71%
e. 7.05%
(9-4) Yield to maturity
C G Answer: b EASY 79 Radoski Corporation's bonds make an annual coupon interest payment of 7.35%. The bonds have a par value of $1,000, a current price of $1,130, and mature in 12 years. What is the yield to maturity on these bonds?
a. 5.52%
b. 5.82%
c. 6.11%
d. 6.41%
e. 6.73%
(9-4) Yield to call
C G
Answer: d EASY
80 Sadik Inc.'s bonds currently sell for $1,180 and have a par value of $1,000. They pay a $105 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100. What is their yield to call (YTC)?
a. 6.63%
b. 6.98%
c. 7.35%
d. 7.74%
e. 8.12%
(9-4) Current yield
C G
Answer: a EASY
81. Malko Enterprises’ bonds currently sell for $1,050. They have a 6-year maturity, an annual coupon of $75, and a par value of $1,000. What is their current yield?
a. 7.14%
b. 7.50%
c. 7.88%
d. 8.27%
e. 8.68%
(9-6) Bond valuation: semiannual
C G
Answer: a EASY
82 Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require an 8.4% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?
©
a. $1,105.69
b. $1,133.34
c. $1,161.67
d. $1,190.71
e. $1,220.48
(9-3) Bond valuation: annual
C G
Answer: e MEDIUM
83 Grossnickle Corporation issued 20-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000 one year ago. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 19 years to maturity?
a. $1,113.48
b. $1,142.03
c. $1,171.32
d. $1,201.35
e. $1,232.15
(9-4) YTM and YTC
C G
Answer: a MEDIUM
84. McCue Inc.'s bonds currently sell for $1,250. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM; it is possible to get a negative answer.)
a. 2.62%
b. 2.88%
c. 3.17%
d. 3.48%
e. 3.83%
(9-4) YTM and YTC
C G
Answer: e MEDIUM
85. Taussig Corp.'s bonds currently sell for $1,150. They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds?
a. 3.42%
b. 3.60%
c. 3.79%
d. 3.99%
e. 4.20%
(9-5) Future annual bond value
C G Answer: c MEDIUM 86. A 25-year, $1,000 par value bond has an 8.5% annual payment coupon. The bond currently sells for $925. If the yield to maturity remains at its current rate, what will the price be 5 years from now?
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a. $884.19
b. $906.86
c. $930.11
d. $953.36
e. $977.20
(9-6) Bond valuation: semiannual C G
Answer: c MEDIUM
87. Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 6.20%, based on semiannual compounding. What is the bond’s price?
a. $1,047.19
b. $1,074.05
c. $1,101.58
d. $1,129.12
e. $1,157.35
(9-6) Market value: semiannual C G
Answer: b MEDIUM
88. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures from historical book values to market values. KJM Corporation's balance sheet (book values) as of today is as follows:
Long-term debt (bonds, at par)
stock ($10 par)
The bonds have a 7.0% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 11%, so the bonds now sell below par. What is the current market value of the firm's debt?
a. $17,436,237
b. $17,883,320
c. $18,330,403
d. $ 7,706,000
e. $ 7,898,650
(9-6) Semiannual YTM and YTC
C G
Answer: b HARD
89 Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,120. What is the bond’s nominal yield to call?
a. 6.20%
b. 6.53%
c. 6.85%
d. 7.20%
e. 7.55%
(9-6) Semiannual bond coupon
C G
Answer: e HARD
90. O'Brien Ltd.'s outstanding bonds have a $1,000 par value, and they mature in 25 years. Their nominal yield to maturity is 9.25%, they pay interest semiannually, and they sell at a price of $975. What is the bond's nominal coupon interest rate?
a. 7.32%
b. 7.71%
(9-6) Bonds: semiannual EFF% C G
Answer: c HARD
91. Kebt Corporation's Class Semi bonds have a 12-year maturity and an 8.75% coupon paid semiannually (4.375% each 6 months), and those bonds sell at their $1,000 par value. The firm's Class Ann bonds have the same risk, maturity, nominal interest rate, and par value, but these bonds pay interest annually. Neither bond is callable. At what price should the annual payment bond sell?
a. $ 937.56
b. $ 961.60
c. $ 986.25
d. $1,010.91
e. $1,036.18
(9-6) Bonds: semiannual & OID C G
Answer: d HARD
92. Moon Software Inc. is planning to issue two types of 25-year, noncallable bonds to raise a total of $6 million, $3 million from each type of bond. First, 3,000 bonds with a 10% semiannual coupon will be sold at their $1,000 par value to raise $3,000,000. These are called “par” bonds. Second, Original Issue Discount (OID) bonds, also with a 25-year maturity and a $1,000 par value, will be sold, but these bonds will have a semiannual coupon of only 6.25%. The OID bonds must be offered at below par in order to provide investors with the same effective yield as the par bonds. How many OID bonds must the firm issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds.
CHAPTER 9 ANSWERS AND SOLUTIONS
The sinking fund would give Bond SF a lower average maturity, and it would also lower its risk. Therefore, Bond SF should have a lower, not a higher, yield.
Floating rates can benefit issuers if rates decline, so a company that thinks rates are likely to fall would want to issue such bonds.
The bonds expected return (YTM) is 13.81%, which exceeds the 12% required return, so buy the bond.
The reason for this is that more of the cash flows of a low-coupon bond comes late in the bond's life (as the maturity payment), and later cash flows are impacted most heavily by changing market rates.
The callable bond will be called if rates fall far enough below the coupon rate, but it will not be called otherwise. Thus, the call provision can only harm bondholders. Therefore, callable bonds sell at higher yields than noncallable bonds, regardless of the slope of the yield curve.
The second bond's convertible feature and sinking fund would tend to lower its required rate of return, but the call feature would raise its rate. Given these opposing forces, the second bond's required coupon rate could be above or below that of the first bond. However, the convertible feature generally dominates in the real world, so convertibles' coupon rates are generally less than comparable nonconvertible issues' rates.
Note that Bond 10 sells at par, so the required return on all these bonds is 10%. 10's price will remain constant; 8 will sell initially at a discount and will rise, and 12 will sell initially at a premium and will decline. Note too that since it has larger cash flows from its higher coupons, Bond 12 would be less sensitive to interest rate changes, i.e., it has less price risk. It has more default risk.
Answers c, d, and e are clearly wrong, and answer b is clearly correct. Answer a is also wrong, but this is not obvious to most people. We can demonstrate that a is incorrect by using the following example.
We can tell by inspection that c, d, and e are all incorrect. a is also incorrect because the 10-year bond will fall more due to its longer maturity and lower coupon. That leaves Answer b as the only possibly correct statement. Recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 10-year, 8% coupon bond should be more sensitive to a decline in rates. You could also do some calculations to confirm that b is correct.
A is a high coupon bond because it sells above par, C is a low coupon bond, and B yields the going market rate. Consider this when ruling out a, b, c, and e. d is obviously correct.
62
a is correct because, with the current market rate below the coupon bond, both bonds will sell at a premium, but the premium will be larger for the noncallable bond. The same logic explains why d is false. 63.
A bond would not be called unless the current rate was below the YTM, in which case it would sell at a premium, because only then would it be profitable to refund the bond. The investor would get the funds, then reinvest at the new low market rate. Thus, the investor would end up earning less than the YTM, even after receiving the call premium. 68
Current yield and YTM
Answer a is incorrect because a premium bond must have a negative capital gains yield. Answer c is incorrect because a bond selling at par must have a current yield equal to its YTM. Answer d is incorrect because a bond selling at below par must have a YTM > the coupon rate. Answer e is incorrect because a discount bond's price must rise over time. That leaves answer b as the only possibly correct answer. Note that YTM = Current yield +/- Capital gains yield, so Current yield = YTM +/- Capital gains yield. The capital gains yield will be positive or negative depending on whether the coupon rate is above or below the YTM. That means that the current yield must either equal the YTM or be between the YTM and the coupon rate. b's correctness is also demonstrated below:
72
We can tell by inspection that c, d, and e are all incorrect. That leaves Answers a and b as the only possibly correct statements. Also, recognize that longer-term bonds, and also bonds whose payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 15-year, 8% coupon bond would be more sensitive to a decline in rates. Finally, we can do some calculations to confirm that a is the correct answer:
The higher the percentage of mortgage bonds, the less the collateral backing each bond, so these bonds' risk and thus required return would be higher. Also, the higher the percentage of mortgage bonds, the less free assets would be backing the debentures, so their risk and required return would also be higher. However, mortgage bonds are less risky than debentures, so mortgage bond rates are lower than rates on debentures. We end up with a situation where the greater the percentage of mortgage bonds, the higher the rate on both types of bonds, but the average cost to the company could be higher, lower, or constant. Note that we could draw a graph of the situation, with % mortgage on the horizontal axis and rates on the vertical axis, the graph would look like the WACC graph in the cost of capital chapter.
73. (Comp.) Costs of types of debt
C G Answer: b HARD
In Statement b, note that if only $500,000 of 1st mortgage bonds were secured by $1 million of property, each of those bonds would be less risky than if there were $1 million of bonds backed by the $1 million of property. Note too that the cost of the total $1 million of debt would be an average of the cost of the mortgage bonds and the debentures, and that average cost could be higher, lower, or the same as if only mortgage bonds or only debentures were used.
74. (Comp.) Bond concepts
C G
Answer: e HARD
It is relatively easy to eliminate a, c, and d. When choosing between b and e, think about the graph that shows the relationship between a bond's price and the going interest rate. This curve is concave, indicating that at any interest rate, the decline in price from an increase in rates is less than the gain in price from a similar interest rate decline. It would be easy to confirm this statement with an example.
75. (9-3) Bond valuation: annual
C G
Answer: a EASY
If the coupon rate exceeds the YTM, then it is likely that the bonds will be called and replaced with new, lower coupon bonds. In that case, the YTC will be earned. Otherwise, one should expect to earn the YTM.
86. (9-5) Future annual bond value
First find the YTM at this time, then use the YTM with the other data to find the bond's price 5 years hence.
First, use the given data to find the bond's current price. Then use that price to find the YTC.
First, use the data provided to find the dollar coupon payment per 6 months, then multiply by 2 to get the annual coupon, and then divide by the par value to find the coupon rate. One could use the indicated data and solve for the price. It would be $975, which confirms the rate.
These two bonds should provide the same EFF%. Therefore, we can find the EFF% for the semiannual bond and then use it as the YTM for the annual payment bond. At the calculated price, the two bonds will have YTMs with the same EFF%. Note too that the semiannual payment bond must have a higher price than the annual bond because then it receives the same cash flow, but faster. Therefore, the annual bond must sell at a price below the $1,000 par value at which the semiannual bond sells.
92 (9-6) Bonds: semiannual & OID C G
Answer: d HARD
The par bond has a coupon rate of 10% and a periodic rate of 5%, and it sells at par. Therefore, the going nominal rate must be 10% with an EFF% of 10.25%. The OID bond must provide the same EFF%, because it is equally risky. Therefore, it must be evaluated with the parameters shown below to find its price, which is then used to find the number of bonds to be issued. Note that if the OID bond is based on a 5% periodic rate, its EFF% will also be 10.25%.
Bond A: Issued at par: Bond B: Issued at a discount (OID bonds):