Fundamentals of financial management concise edition 8th edition brigham test bank

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Chapter 7: Bonds and Their Valuation

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

ANSWER: True

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

ANSWER: False

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

ANSWER: True

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

ANSWER: False

Chapter 7: Bonds and Their Valuation

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 ANSWER: True

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 ANSWER: True

Chapter 7: Bonds and Their Valuation

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

ANSWER: True

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

ANSWER: False

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

ANSWER: False

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

ANSWER: True

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

ANSWER: True

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

ANSWER: True

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 ANSWER: False

Chapter 7: Bonds and Their Valuation

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

ANSWER: False

RATIONALE: 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.

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

ANSWER: False

RATIONALE: Floating rates can benefit issuers if rates decline, so a company that thinks rates are likely to fall would want to issue such bonds.

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 are below 10% and at a discount if interest rates are greater than 10%.

a. True

b. False

ANSWER: True

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

ANSWER: True

RATIONALE: The bonds expected return (YTM) is 13.81%, which exceeds the 12% required return, so buy the bond.

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

ANSWER: True

Chapter 7: Bonds and Their Valuation

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

ANSWER: True

RATIONALE: 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.

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

ANSWER: True

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

ANSWER: True

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

ANSWER: False

RATIONALE: 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.

23. Which of the following statements is CORRECT?

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.

ANSWER: a

Chapter 7: Bonds and Their Valuation

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.

ANSWER: c

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% A = 9.64%

AAA = 8.72% 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.

ANSWER: c

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.

ANSWER: b

27. Which of the following statements is CORRECT?

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.

ANSWER: a

Chapter 7: Bonds and Their Valuation

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%.

ANSWER: b

RATIONALE: 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 non-convertible issues’ rates.

29. Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds noncallable, 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.

ANSWER: d

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.

ANSWER: a

31. Which of the following statements is CORRECT?

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.

ANSWER: c

Chapter 7: Bonds and Their Valuation

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.

ANSWER: c

33. Which of the following statements is CORRECT?

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.

ANSWER: d

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.

ANSWER: d

RATIONALE: 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.

Chapter 7: Bonds and Their Valuation

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.

ANSWER: b

RATIONALE: 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.

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.

ANSWER: c

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.

ANSWER: b

RATIONALE: 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 10year, 8% coupon bond should be more sensitive to a decline in rates. You could also do some calculations to confirm that b is correct.

Chapter 7: Bonds and Their Valuation

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.

ANSWER: c

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.

ANSWER: e

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.

ANSWER: d

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.

ANSWER: b

Chapter 7: Bonds and Their Valuation

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.

ANSWER: e

43. Which of the following statements is CORRECT?

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 high-coupon 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.

ANSWER: e

44. Which of the following statements is CORRECT?

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.

ANSWER: d

45. Which of the following statements is CORRECT?

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.

ANSWER: e

Chapter 7: Bonds and Their Valuation

46. Which of the following statements is CORRECT?

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.

ANSWER: e

47. Which of the following statements is CORRECT?

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.

ANSWER: a

48. Which of the following statements is CORRECT?

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.

ANSWER: a

49. 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%.

ANSWER: d

Chapter 7: Bonds and Their Valuation

50. 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.

ANSWER: e

51. 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.

ANSWER: b

52. Which of the following statements is CORRECT?

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.

ANSWER: e

53. Which of the following statements is CORRECT?

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. Longer-term low-coupon bonds, relative to shorter-term high-coupon bonds, are generally more exposed to reinvestment risk than price risk.

ANSWER: b

Chapter 7: Bonds and Their Valuation

54. Which of the following statements is CORRECT?

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.

ANSWER: e

55. Which of the following statements is CORRECT?

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

ANSWER: a

56. 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.

ANSWER: a

Chapter 7: Bonds and Their Valuation

57. 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.

ANSWER: d

RATIONALE: 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.

58. Which of the following statements is CORRECT?

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%.

ANSWER: c

59. Which of the following statements is CORRECT?

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.

ANSWER: d

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