Corporate Finance A Focused Approach 5th Edition By Ehrhardt, Michael C. - Test Bnak

Corporate Finance A Focused Approach 5th Edition By Ehrhardt, Michael C. – Test Bnak

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CHAPTER 5—BONDS, BOND VALUATION, AND INTEREST RATES

TRUE/FALSE

If a firm raises capital by selling new bonds, it is called the “issuing firm,” and the coupon rate is generally set equal to the required rate on bonds of equal risk.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Issuing bonds KEY: Bloom’s: Knowledge

A call provision gives bondholders the right to demand, or “call for,” repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

ANS: F PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Call provision KEY: Bloom’s: Knowledge

Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Sinking funds KEY: Bloom’s: Knowledge

A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially) at par. These bonds provide compensation to investors in the form of capital appreciation.

ANS: F PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Zero coupon bond KEY: Bloom’s: Knowledge

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.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Floating-rate debt KEY: Bloom’s: Knowledge

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.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Discounted cash flows KEY: Bloom’s: Knowledge

For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond prices and interest rates KEY: Bloom’s: Knowledge

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.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Mortgage bond KEY: Bloom’s: Knowledge

Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Debt coupon rate KEY: Bloom’s: Knowledge

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.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond ratings and required returns KEY: Bloom’s: Knowledge

A bond that had a 20-year original maturity with 1 year left to maturity has more interest rate 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.)

ANS: F PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-13 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Knowledge

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 interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond.

ANS: F PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-13 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Knowledge

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.

ANS: T PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-15 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Junk bond KEY: Bloom’s: Knowledge

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.

ANS: F

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.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2

NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Callable bonds

KEY: Bloom’s: Comprehension

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.

ANS: F PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Income bond KEY: Bloom’s: Comprehension

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.

ANS: F

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.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2

NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Sinking funds KEY: Bloom’s: Comprehension

Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floating-rate debt shifts interest rate risk to companies, it offers no advantages to issuers.

ANS: F

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

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2

NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Floating-rate debt KEY: Bloom’s: Comprehension

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

ANS: T PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond premiums and discounts KEY: Bloom’s: Comprehension

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%.

ANS: T

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

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-3

NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond value–annual payment KEY: Bloom’s: Comprehension

If the required rate of return on a bond (r_d) 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.)

ANS: T PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond value KEY: Bloom’s: Comprehension

“Restrictive covenants” are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures.

ANS: T PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Restrictive covenants KEY: Bloom’s: Comprehension

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.

ANS: T

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.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13

NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds

LOC: TBA TOP: Prices and interest rates KEY: Bloom’s: Comprehension

MULTIPLE CHOICE

Which of the following statements is CORRECT?

a.	The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates.
b.	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.
c.	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.
d.	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.
e.	You hold two bonds. One is a 10-year, zero coupon, issue 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 larger percentage decline.

ANS: E PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rates KEY: Bloom’s: Comprehension

MSC: TYPE: Multiple Choice: Conceptual

Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds?

a.	Market interest rates rise sharply.
b.	Market interest rates decline sharply.
c.	The company’s financial situation deteriorates significantly.
d.	Inflation increases significantly.
e.	The company’s bonds are downgraded.

ANS: B PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Callable bonds

KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual

A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT?

a.	The bond is selling below its par value.
b.	The bond is selling at a discount.
c.	If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price.
d.	The bond’s current yield is greater than 9%.
e.	If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price.

ANS: C PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Comprehension

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	An indenture is a bond that is less risky than a mortgage bond.
b.	The expected return on a corporate bond will generally exceed the bond’s yield to maturity.
c.	If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity.
d.	Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.
e.	All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

ANS: E PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bonds, default risk KEY: Bloom’s: Comprehension

MSC: TYPE: Multiple Choice: Conceptual

Ranger Inc. would like to issue new 20-year bonds. Initially, the plan was to make the bonds non-callable. If the bonds were made callable after 5 years at a 5% call premium, how would this affect their required rate of return?

a.	There is no reason to expect a change in the required rate of return.
b.	The required rate of return would decline because the bond would then be less risky to a bondholder.
c.	The required rate of return would increase because the bond would then be more risky to a bondholder.
d.	It is impossible to say without more information.
e.	Because of the call premium, the required rate of return would decline.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-2 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Call provision KEY: Bloom’s: Comprehension

MSC: TYPE: Multiple Choice: Conceptual

Under normal conditions, which of the following would be most likely to increase the coupon rate required to enable a bond to be issued at par?

a.	Adding a call provision.
b.	The rating agencies change the bond’s rating from Baa to Aaa.
c.	Making the bond a first mortgage bond rather than a debenture.
d.	Adding a sinking fund.
e.	Adding additional restrictive covenants that limit management’s actions.

ANS: A PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-3 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond coupon rate KEY: Bloom’s: Comprehension

MSC: TYPE: Multiple Choice: Conceptual

Which of the following bonds would have the greatest percentage increase in value if all interest rates fall by 1%?

a.	20-year, 10% coupon bond.
b.	20-year, 5% coupon bond.
c.	1-year, 10% coupon bond.
d.	20-year, zero coupon bond.
e.	10-year, zero coupon bond.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Comprehension

MSC: TYPE: Multiple Choice: Conceptual

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.	A 1-year bond with a 15% coupon.
b.	A 3-year bond with a 10% coupon.
c.	A 10-year zero coupon bond.
d.	A 10-year bond with a 10% coupon.
e.	An 8-year bond with a 9% coupon.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Comprehension

MSC: TYPE: Multiple Choice: Conceptual

Which of the following bonds has the greatest interest rate price risk?

a.	A 10-year, $1,000 face value, zero coupon bond.
b.	A 10-year, $1,000 face value, 10% coupon bond with annual interest payments.
c.	All 10-year bonds have the same price risk since they have the same maturity.
d.	A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.

ANS: A PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

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 bond with an 8% coupon.
b.	A 10-year bond with an 8% coupon.
c.	A 10-year bond with a 12% coupon.
d.	A 10-year zero coupon bond.
e.	A 1-year zero coupon bond.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature.
b.	A sinking fund provision makes a bond more risky to investors at the time of issuance.
c.	Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time.
d.	If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price.
e.	Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued.

ANS: E PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-2 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Sinking funds KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Nicholas Industries can issue a 20-year bond with a 6% annual coupon. This bond is not convertible, is not callable, and has no sinking fund. Alternatively, Nicholas 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 Nicholas would have to pay on the convertible, callable bond?

a.	It could be less than, equal to, or greater than 6%.
b.	Greater than 6%.
c.	Exactly equal to 8%.
d.	Less than 6%.
e.	Exactly equal to 6%.

ANS: A PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-2 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Convertible, callable bonds KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

The YTMs of three $1,000 face value bonds that mature in 10 years and have the same level of risk are equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 10 years, which of the following statements is CORRECT?

a.	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.
b.	Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year.
c.	Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year.
d.	Over the next year, Bond A’s price is expected to decrease, Bond B’s price is expected to stay the same, and Bond C’s price is expected to increase.
e.	Bond A’s current yield will increase each year.

ANS: C

Note that Bond B sells at par, so the required return on all these bonds is 10%. B’s price will remain constant; A will sell initially at a discount and will rise, and C will sell initially at a premium and will decline. Note too that since it has larger cash flows from its higher coupons, Bond C would be less sensitive to interest rate changes; i.e., it has less interest rate risk. Perhaps it has less default risk.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-3

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

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 NOT CORRECT?

a.	The bond’s yield to maturity is 9%.
b.	The bond’s current yield is 9%.
c.	If the bond’s yield to maturity remains constant, the bond will continue to sell at par.
d.	The bond’s current yield exceeds its capital gains yield.
e.	The bond’s expected capital gains yield is positive.

ANS: E PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at par.
b.	All else equal, if a bond’s yield to maturity increases, its price will fall.
c.	If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at a premium over par.
d.	All else equal, if a bond’s yield to maturity increases, its current yield will fall.
e.	A zero coupon bond’s current yield is equal to its yield to maturity.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Stephenson Co.’s 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 current yield exceeds its yield to maturity.
b.	The bond’s yield to maturity is greater than its coupon rate.
c.	The bond’s current yield is equal to its coupon rate.
d.	If the yield to maturity stays constant until the bond matures, the bond’s price will remain at $850.
e.	The bond’s coupon rate exceeds its current yield.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

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.	If the yield to maturity remains at 8%, then the bond’s price will decline over the next year.
b.	The bond’s coupon rate is less than 8%.
c.	If the yield to maturity increases, then the bond’s price will increase.
d.	If the yield to maturity remains at 8%, then the bond’s price will remain constant over the next year.
e.	The bond’s current yield is less than 8%.

ANS: A

Answers b, c, and d are clearly wrong, and answer a is clearly correct. Answer e is also wrong, but this is not obvious to most people. We can demonstrate that e is incorrect by using the following example.

Par	$1,000
YTM	8.00%
Maturity	10
Price	$1,100
Payment	$94.90
Coupon rate	9.49%
Current yield	8.63%	The current yield is greater than 8%.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	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.
b.	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.
c.	If a coupon bond is selling at par, its current yield equals its 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 bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

A 15-year bond has an annual coupon rate of 8%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 6%. Which of the following statements is CORRECT?

a.	The bond is currently selling at a price below its par value.
b.	If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today.
c.	The bond should currently be selling at its par value.
d.	If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.
e.	If market interest rates decline, the price of the bond will also decline.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rates and bond prices KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

An 8-year Treasury bond has a 10% coupon, and a 10-year Treasury bond has an 8% coupon. Both bonds 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.	Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.
b.	The prices of both bonds would increase by the same amount.
c.	One bond’s price would increase, while the other bond’s price would decrease.
d.	The prices of the two bonds would remain constant.
e.	The prices of both bonds will decrease by the same amount.

ANS: A

We can tell by inspection that b, c, d, and e are all incorrect. That leaves answer a 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 a is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-4

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rates and bond prices KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

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 prices of both bonds will remain unchanged.
b.	The price of Bond A will decrease over time, but the price of Bond B will increase over time.
c.	The prices of both bonds will increase by 7% per year.
d.	The prices of both bonds will increase over time, but the price of Bond A will increase by more.
e.	The price of Bond B will decrease over time, but the price of Bond A will increase over time.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields and prices KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Assume that interest rates on 15-year noncallable Treasury and corporate bonds with different ratings 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.	Tax effects.
b.	Default risk differences.
c.	Maturity risk differences.
d.	Inflation differences.
e.	Real risk-free rate differences.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-7 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rates KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	All else equal, long-term bonds have less interest rate price risk than short-term bonds.
b.	All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds.
c.	All else equal, short-term bonds have less reinvestment rate risk than long-term bonds.
d.	All else equal, long-term bonds have less reinvestment rate risk than short-term bonds.
e.	All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest vs. reinvestment rate risk KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds.
b.	If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk.
c.	Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk.
d.	Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds.
e.	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.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest vs. reinvestment rate risk KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	Liquidity premiums are generally higher on Treasury than corporate bonds.
b.	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.
c.	Default risk premiums are generally lower on corporate than on Treasury bonds.
d.	Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
e.	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.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Term structure of interest rates KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.
b.	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.
c.	If a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a premium.
d.	If a coupon bond is selling at a premium, its current yield equals its yield to maturity.
e.	If a coupon bond is selling at par, its current yield equals its yield to maturity.

ANS: E PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

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 has a current yield greater than 8%.
b.	The bond sells at a discount.
c.	The bond’s required rate of return is less than 7.5%.
d.	If the yield to maturity remains constant, the price of the bond will decline over time.
e.	The bond sells at a price below par.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Bonds A and B are 15-year, $1,000 face value 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%, which is expected to remain constant for the next 15 years. Which of the following statements is CORRECT?

a.	One year from now, Bond A’s price will be higher than it is today.
b.	Bond A’s current yield is greater than 8%.
c.	Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.
d.	Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.
e.	Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.

ANS: A PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is NOT CORRECT?

a.	All else equal, bonds with longer maturities have more interest rate (price) risk than bonds with shorter maturities.
b.	If a bond is selling at its par value, its current yield equals its yield to maturity.
c.	If a bond is selling at a premium, its current yield will be greater than its yield to maturity.
d.	All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds with smaller coupons.
e.	If a bond is selling at a discount to par, its current yield will be less than its yield to maturity.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where r_d = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value.
b.	Other things held constant, a corporation would rather issue noncallable bonds than callable bonds.
c.	Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond.
d.	Reinvestment rate risk is worse from an investor’s standpoint than interest rate price risk if the investor has a short investment time horizon.
e.	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 r_d = YTM = 5%, the bond would sell at a premium over its $1,000 par value.

ANS: A PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	The total yield on a bond is derived from dividends plus changes in the price of the bond.
b.	Bonds are riskier than common stocks and therefore have higher required returns.
c.	Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies.
d.	The market value of a bond will always approach its par value as its maturity date approaches, provided the bond’s required return remains constant.
e.	If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	If rates fall after its issue, a zero coupon bond could trade at a price above its par value.
b.	If rates fall rapidly, a zero coupon bond’s expected appreciation could become negative.
c.	If a firm moves from a position of strength toward financial distress, its bonds’ yield to maturity would probably decline.
d.	If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon rate.
e.	If a coupon bond is selling at par, its current yield equals its yield to maturity.

ANS: E PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

You are considering three different bonds for your portfolio. Each bond has a 10-year maturity and a yield to maturity of 10%. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Which of the following statements is CORRECT?

a.	Bond X has the greatest reinvestment rate risk.
b.	If market interest rates decline, all of the bonds will have an increase in price, and Bond Z will have the largest percentage increase in price.
c.	If market interest rates remain at 10%, Bond Z’s price will be 10% higher one year from today.
d.	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.
e.	If the bonds’ market interest rates remain at 10%, Bond Z’s price will be lower one year from now than it is today.

ANS: E PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Bonds A, B, and C all have a maturity of 15 years and a yield to maturity of 9%. 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. Which of the following statements is CORRECT?

a.	Bond A has the most interest rate risk.
b.	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.
c.	If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.
d.	Bond C sells at a premium over its par value.
e.	If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5% coupon bond (assuming all else equal).
b.	The total 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.
c.	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.
d.	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%.
e.	10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10% coupon bonds.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	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.
b.	Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices.
c.	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.
d.	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.
e.	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.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	If a coupon bond is selling at a discount, then the bond’s expected capital gains yield is negative.
b.	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.
c.	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.
d.	If a coupon bond is selling at par, its current yield equals its yield to maturity.
e.	If a coupon bond is selling at a premium, then the bond’s current yield is zero.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.
b.	Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.
c.	If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
d.	The yield curve can never be downward sloping.
e.	If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the yield curve will have an upward slope.

ANS: E

The slope of the yield curve depends primarily on expected inflation and the MRP. The greater the expected increase in inflation, and the higher the MRP, the steeper the slope of the yield curve. If inflation is expected to decline, then even if the MRP is positive, the curve could still have a downward slope.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-14

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yield curve KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that

a.	The economy is not in a recession.
b.	Long-term bonds are a better buy than short-term bonds.
c.	Maturity risk premiums could help to explain the yield curve’s upward slope.
d.	Long-term interest rates are more volatile than short-term rates.
e.	Inflation is expected to decline in the future.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yield curve KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	The most likely explanation for an inverted yield curve is that investors expect inflation to increase.
b.	The most likely explanation for an inverted yield curve is that investors expect inflation to decrease.
c.	If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.
d.	Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.
e.	The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yield curve KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Bonds for two companies were just issued: Short Corp.’s bonds will mature in 5 years, and Long Corp.’s bonds will mature in 15 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further, assume that the Treasury yield curve is based only on expectations about future inflation, i.e., that the maturity risk premium is zero for T-bonds. Under these conditions, which of the following statements is correct?

a.	If the Treasury yield curve is downward sloping, Long’s bonds must under all conditions have the lower yield.
b.	If the yield curve for Treasury securities is upward sloping, Long’s bonds must under all conditions have a higher yield than Short’s bonds.
c.	If the yield curve for Treasury securities is flat, Short’s bond must under all conditions have the same yield as Long’s bonds.
d.	If Long’s and Short’s bonds have the same default risk, their yields must under all conditions be equal.
e.	If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short’s bonds must under all conditions have the lower yield.

ANS: E PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Corporate yield curve KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

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, and an 8% yield to maturity. Which of the following statements is CORRECT?

a.	Bond A trades at a discount, whereas Bond B trades at a premium.
b.	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.
c.	If the yield to maturity for both bonds immediately decreases to 6%, Bond A’s bond will have a larger percentage increase in value.
d.	Bond A’s current yield is greater than that of Bond B.
e.	Bond A’s capital gains yield is greater than Bond B’s capital gains yield.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond rates and prices KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond.
b.	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.
c.	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.
d.	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.
e.	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.

ANS: E PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Callable bonds KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Cornwall Corporation is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT?

a.	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.
b.	If two tiers of debt are used (with one senior and one subordinated debt class), the subordinated debt will carry a lower interest rate.
c.	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.
d.	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.
e.	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.

ANS: A

On statement a, 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 cost could be higher, lower, or the same as if only mortgage bonds or debentures were used.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-11

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Costs of types of debt KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	Subordinated debt has less default risk than senior debt.
b.	Convertible bonds have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains.
c.	Junk bonds typically provide a lower yield to maturity than investment-grade bonds.
d.	A debenture is a secured bond that is backed by some or all of the firm’s fixed assets.
e.	Junior debt is debt that has been more recently issued, and in bankruptcy it is paid off after senior debt because the senior debt was issued first.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-15 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Types of debt KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond.
b.	Once a firm declares bankruptcy, it must then be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and lawyer fees.
c.	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.
d.	A firm with a sinking fund that gave 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.
e.	One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the debt until the bonds mature.

ANS: C PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	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%.
b.	The price of a discount bond will increase over time, assuming that the bond’s yield to maturity remains constant.
c.	For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds.
d.	When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized.
e.	The total return on a bond during a given year consists only of the coupon interest payments received.

ANS: B PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is NOT CORRECT?

a.	The expected return on a corporate bond must be less than its promised return if the probability of default is greater than zero.
b.	All else equal, senior debt has less default risk than subordinated debt.
c.	A company’s bond rating is affected by its financial ratios and provisions in its indenture.
d.	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 its debt according to the seniority of the debt as spelled out in the Act.
e.	All else equal, secured debt is less risky than unsecured debt.

ANS: D PTS: 1 DIF: Difficulty: Moderate

OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Default and bankruptcy KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	A bond is likely to be called if its market price is below its par value.
b.	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.
c.	A bond is likely to be called if its market price is equal to its par value.
d.	A bond is likely to be called if it sells at a discount below par.
e.	A bond is likely to be called if its coupon rate is below its YTM.

ANS: B

A bond would not be called unless the current rate was below the YTM. The investor would get the funds, then reinvest at the new market rate. Thus, the investor would end up earning less than the YTM, even after receiving the call premium.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Call provision KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	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.
b.	If a bond sells at par, then its current yield will be less than its yield to maturity.
c.	If a bond sells for less than par, then its yield to maturity is less than its coupon rate.
d.	A discount bond’s price declines each year until it matures, when its value equals its par value.
e.	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.

ANS: A

Answer b is incorrect because a bond selling at par must have a current yield equal to its YTM.

Answer c is incorrect because a bond selling at below par must have a YTM > the coupon rate.

Answer d is incorrect because a discount bond’s price must rise over time.

Answer e is incorrect because a premium bond must have a negative capital gains yield.

That leaves Answer a as the only possibly correct answer. Note that YTM = Cur Yld +/- Cap gains Yld., so Cur Yld = YTM +/- Cap gain yld. The cap gains yld will be positive or negative depending on whether the coupon rate is above or below the YTM. That means that the Cur yld must either equal the YTM or be between the YTM and the coupon rate. a’s correctness is also demonstrated below:

	Par bond	Premium	Discount
Par	1000	1000	1000
Maturity	10	10	10
Coup rate	10%	11%	9%
YTM	10.00%	10.00%	10.00%
Ann coup	$100.00	$110.00	$90.00
Price	$1,000.00	$1,061.45	$938.55
Cur Yield	10.00%	10.36%	9.59%	Equal to or between YTM and coupon rate.
Cap gain	0.00%	-0.36%	0.41%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Current yield and yield to maturity KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Assume that a 10-year Treasury bond has a 12% annual coupon, while a 15-year 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 will increase, but the 10-year bond would have a larger percentage increase in price.
b.	The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium.
c.	The 10-year bond would sell at a premium, while the 15-year bond would sell at par.
d.	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.
e.	If interest rates decline, the prices of both bonds will increase, but the 15-year bond would have a larger percentage increase in price.

ANS: E

We can tell by inspection that b, c, and d are all incorrect. That leaves answers a and e as the only possibly correct statements. Also, 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 15-year, 8% coupon bond should be more sensitive to a decline in rates. Finally, we can do some calculations to confirm that e is the correct answer:

	Current situation		Rates decline
	10-year	15-year	10-year	15-year
Par	1000	1000	1000	1000
Maturity	10	15	10	15
Coup rate	12%	8%	12%	8%
YTM	10.00%	10.00%	9.00%	9.00%
Ann coup	120	80	120	80
Price	$1,122.89	$847.88	$1,192.53	$919.39
% Gain			6.2%	8.4%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-4

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Effect of interest rate on bond prices

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

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 prevent the use of additional debt.

a.	1, 4, 6
b.	1, 2, 3, 4, 6
c.	1, 2, 3, 4, 5, 6
d.	1, 3, 4, 5, 6
e.	1, 3, 4, 6

ANS: E PTS: 1 DIF: Difficulty: Challenging

OBJ: LO: 5-11 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond indenture KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Suppose International Digital Technologies decides to raise a total of $200 million, with $100 million as long-term debt and $100 million as common equity. 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.	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.
b.	In this situation, we cannot tell for sure how, or 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 of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm’s total interest charges would not be affected materially by the mix between the two.
c.	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.
d.	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.
e.	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.

ANS: B

The higher the percentage of mortgage bonds, the less the collateral backing each bond, so the 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, then the graph would look like the WACC graph in the cost of capital chapter.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-11

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Types of debt and their relative costs

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	If their maturities and other characteristics were the same, a 5% coupon bond would have more interest rate price risk than a 10% coupon bond.
b.	A 10-year coupon bond would have more reinvestment rate risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment rate risk.
c.	A 10-year coupon bond would have more interest rate price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of interest rate price risk.
d.	If their maturities and other characteristics were the same, a 5% coupon bond would have less interest rate price risk than a 10% coupon bond.
e.	A zero coupon bond of any maturity will have more interest rate price risk than any coupon bond, even a perpetuity.

ANS: A PTS: 1 DIF: Difficulty: Challenging

OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Interest rate and reinvestment rate risk

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

Which of the following statements is CORRECT?

a.	All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds.
b.	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.
c.	If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value.
d.	If a bond’s yield to maturity exceeds its coupon rate, the bond’s current yield must be less than its coupon rate.
e.	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 the bond’s coupon rates.

ANS: C PTS: 1 DIF: Difficulty: Challenging

OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond yields and prices KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Assuming all else is constant, which of the following statements is CORRECT?

a.	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.
b.	From a corporate borrower’s point of view, interest paid on bonds is not tax-deductible.
c.	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.
d.	For a bond of any maturity, a 1.0 percentage point increase in the market interest rate (r_d) causes a larger dollar capital loss than the capital gain stemming from a 1.0 percentage point decrease in the interest rate.
e.	A 20-year zero coupon bond has more reinvestment rate risk than a 20-year coupon bond.

ANS: D

It is relatively easy to eliminate b, c, and e. When choosing between a and d, 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.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-13

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Conceptual

Kessen Inc.’s bonds mature in 7 years, have a par value of $1,000, and make an annual coupon payment of $70. The market interest rate for the bonds is 8.5%. What is the bond’s price?

a.	$923.22
b.	$946.30
c.	$969.96
d.	$994.21
e.	$1,019.06

ANS: A

N	7
I/YR	8.5%
PMT	$70
FV	$1,000
PV	$923.22

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-3

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond valuation KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

Noncallable bonds that mature in 10 years were recently issued by Sternglass Inc. They have a par value of $1,000 and an annual coupon of 5.5%. If the current market interest rate is 7.0%, at what price should the bonds sell?

a.	$829.21
b.	$850.47
c.	$872.28
d.	$894.65
e.	$917.01

ANS: D

Coupon rate	5.5%
PMT	$55
N	10
I/YR	7.0%
FV	$1,000
PV	$894.65

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-3

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond valuation KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

Curtis Corporation’s noncallable bonds currently sell for $1,165. They have a 15-year maturity, an annual coupon of $95, and a par value of $1,000. What is their yield to maturity?

a.	6.20%
b.	6.53%
c.	6.87%
d.	7.24%
e.	7.62%

ANS: E

N	15
PV	$1,165
PMT	$95
FV	$1,000
I/YR	7.62%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yield to maturity KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

Sommers Co.’s bonds currently sell for $1,080 and have a par value of $1,000. They pay a $100 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,125. What is their yield to maturity (YTM)?

a.	8.56%
b.	9.01%
c.	9.46%
d.	9.93%
e.	10.43%

ANS: B

N	15
PV	$1,080
PMT	$10
FV	$1,000
I/YR	9.01%	= YTM

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yield to maturity KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

Sentry Corp. bonds have an annual coupon payment of 7.25%. The bonds have a par value of $1,000, a current price of $1,125, and they will mature in 13 years. What is the yield to maturity on these bonds?

a.	5.56%
b.	5.85%
c.	6.14%
d.	6.45%
e.	6.77%

ANS: B

Coupon rate	7.25%
N	13
PV = Price	$1,125
PMT	$72.50
FV = Par	$1,000
I/YR	5.85%	= YTM

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yield to maturity KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

Meacham Enterprises’ bonds currently sell for $1,280 and have a par value of $1,000. They pay a $135 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,050. What is their yield to call (YTC)?

a.	6.39%
b.	6.72%
c.	7.08%
d.	7.45%
e.	7.82%

ANS: D

N	5
PV	$1,280
PMT	$135
FV	$1,050
I/YR = YTC	7.45%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yield to call KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

Perry Inc.’s bonds currently sell for $1,150. They have a 6-year maturity, an annual coupon of $85, and a par value of $1,000. What is their current yield?

a.	7.39%
b.	7.76%
c.	8.15%
d.	8.56%
e.	8.98%

ANS: A

N	6
PV	$1,150
PMT	$85
FV	$1,000
Current yield =	7.39%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Current yield KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

Rogoff Co.’s 15-year bonds have an annual coupon rate of 9.5%. Each bond has face value of $1,000 and makes semiannual interest payments. If you require an 11.0% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

a.	$891.00
b.	$913.27
c.	$936.10
d.	$959.51
e.	$983.49

ANS: A

Par value	$1,000
Coupon rate	9.5%
Periods/year	2
Yrs to maturity	15
N = periods	30
Annual rate	11.0%
Periodic rate	5.50%
PMT/period	$47.50
FV	$1,000
PV	$891.00

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-5

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond valuation: semiannual coupons

KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem

If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond?

a.	1.90%
b.	2.09%
c.	2.30%
d.	2.53%
e.	2.78%

ANS: A

T-bond yield		6.20%
Corporate yield		8.50%
MRP	Included in both bonds	1.30%
LP	Included in corporate	0.40%
DRP		1.90%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-11

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Default risk premium (DRP) KEY: Bloom’s: Application

MSC: TYPE: Multiple Choice: Problem

One year ago Lerner and Luckmann Co. issued 15-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 14 years to maturity?

a.	$1,077.01
b.	$1,104.62
c.	$1,132.95
d.	$1,162.00
e.	$1,191.79

ANS: E

Par value	$1,000
Coupon rate	7.5%
N	14
I/YR	5.5%
PMT	$75
FV	$1,000
PV	$1,191.79

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-3

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond valuation: annual coupons KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Currently, Bruner Inc.’s bonds sell for $1,250. They pay a $120 annual coupon, have a 15-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.)

a.	2.11%
b.	2.32%
c.	2.55%
d.	2.80%
e.	3.09%

ANS: A

If held to maturity:		If called in 5 years:
N = Maturity	15	N = Call	5
PV	$1,250	PV	$1,250
PMT	$120	PMT	$120
FV = Par	$1,000	FV = Call Price	$1,050
I/YR = YTM	8.91%	I/YR = YTC	6.81%

Difference:	2.11%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yields to maturity and call KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Gilligan Co.’s bonds currently sell for $1,150. They have a 6.75% annual coupon rate and a 15-year maturity, and are callable in 6 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, the YTC or the YTM?

a.	3.92%
b.	4.12%
c.	4.34%
d.	4.57%
e.	4.81%

ANS: E

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.

If held to maturity				If called
Par value	$1,000			Par value	$1,000
Coupon	6.75%			Coupon	6.75%
N	15			N	6
PV	$1,150.00			PV	$1,150.00
PMT	$67.50			PMT	$67.50
FV	$1,000.00			FV	$1,067.50
I/YR	5.28%		YTM	I/YR	4.81%	YTC

Expected rate of return:		4.81%	YTC

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yields to maturity and call KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Haswell Enterprises’ bonds have a 10-year maturity, a 6.25% semiannual coupon, and a par value of $1,000. The going interest rate (r_d) is 4.75%, based on semiannual compounding. What is the bond’s price?

a.	1,063.09
b.	1,090.35
c.	1,118.31
d.	1,146.27
e.	1,174.93

ANS: C

Par value	$1,000
Coupon rate	6.25%
Periods/year	2
Yrs to maturity	10
N = periods	20
Annual rate	4.75%
Periodic rate	2.38%
PMT/period	$31.25
FV	$1,000
PV	$1,118.31

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-5

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond valuation: semiannual coupons

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

CMS Corporation’s balance sheet as of today is as follows:

Long-term debt (bonds, at par)	$10,000,000
Preferred stock	2,000,000
Common stock ($10 par)	10,000,000
Retained earnings	4,000,000
Total debt and equity	$26,000,000

The bonds have a 4.0% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 12%, so the bonds now sell below par. What is the current market value of the firm’s debt?

a.	$5,276,731
b.	$5,412,032
c.	$5,547,332
d.	$7,706,000
e.	$7,898,650

ANS: B

Calculate the price of each bond:

Coupon rate	4.0%
Par value	$1,000
Maturity (Yrs)	10
Periods/Yr.	2
YTM	12.0%

N	20
I/YR	6.0%
PMT	$20.00
FV	$1,000
PV	$541.20

Determine the number of bonds:

Book value on balance sheet	$10,000,000
Par value	$1,000
Number of bonds = Book value/Par value	10,000

Calculate the market value of bonds:
Mkt value = PV ´ Number of bonds =	$5,412,032

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-5

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Market value of semiannual bonds KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year bonds is 0.4%. What is the real risk-free rate, r*?

a.	2.59%
b.	2.88%
c.	3.20%
d.	3.52%
e.	3.87%

ANS: C

r_T-bond		5.50%
IP	Included in both bonds	1.90%
MRP	Included in both bonds	0.40%
r*		3.20%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-8

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Real risk-free rate KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

The Gergen Group’s 5-year bonds yield 6.85%, and 5-year T-bonds yield 4.75%. The real risk-free rate is r* = 2.80%, the default risk premium for Gergen’s bonds is DRP = 0.85% versus zero for T-bonds, the liquidity premium on Gergen’s bonds is LP = 1.25%, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) ´ 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on 5-year bonds?

a.	1.40%
b.	1.55%
c.	1.71%
d.	1.88%
e.	2.06%

ANS: B

Maturity		5
r_Krockett		6.85%
r_T-bond		4.75%
r*	Included in both bonds	2.80%
LP	Included in corp. only	1.25%
DRP	Included in corp. only	0.85%
MRP	Included in both bonds	0.40%
IP		1.55%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-9

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Inflation premium (IP) KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Chandler Co.’s 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Chandler’s bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) ´ 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Chandler’s bonds?

a.	0.99%
b.	1.10%
c.	1.21%
d.	1.33%
e.	1.46%

ANS: B

Maturity		5
r_Keys’		7.00%
r_T-bond		5.15%
r*	Included in both bonds	3.00%
IP	Included in both bonds	1.75%
LP	Included in corp. only	0.75%
MRP	Included in both bonds	0.40%
DRP		1.10%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-11

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Default risk premium (DRP) KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Squire Inc.’s 5-year bonds yield 6.75%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Squire’s bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) ´ 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Squire’s bonds?

a.	0.49%
b.	0.55%
c.	0.61%
d.	0.68%
e.	0.75%

ANS: E

Maturity		5
r_Nie		6.75%
r_T-bond		4.80%
r*	Included in both bonds	2.75%
IP	Included in both bonds	1.65%
DRP	Included in corp. only	1.20%
MRP	Included in both bonds	0.40%
LP		0.75%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-12

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Liquidity premium (LP) KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Field Industries’ outstanding bonds have a 25-year maturity and $1,000 par value. Their nominal yield to maturity is 9.25%, they pay interest semiannually, and they sell at a price of $850. What is the bond’s nominal (annual) coupon interest rate?

a.	6.27%
b.	6.60%
c.	6.95%
d.	7.32%
e.	7.70%

ANS: E

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 $850, which confirms the rate.

Par value	$1,000
Maturity	25
Periods/year	2
N	50
YTM	9.25%
Periodic rate	4.63%
PV	$850.00
PMT	$38.50
Coupon rate =	7.70%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Determining the coupon rate KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Jerome Corporation’s bonds have 15 years to maturity, an 8.75% coupon paid semiannually, 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 $1,050. What is the bond’s nominal yield to call?

a.	5.01%
b.	5.27%
c.	5.54%
d.	5.81%
e.	6.10%

ANS: B

First, use the given data to find the bond’s current price. Then use that price to find the YTC.

Coupon rate	8.75%	Yrs to call	6
YTM	6.50%	Call price	$1,050.00
Maturity	15
Par value	$1,000
Periods/year	2	Determine the bond’s YTC
Determine the bond’s price		N	12
PMT/period	$43.75	PV	$1,213.55
N	30	PMT	$43.75
I/YR	3.25%	FV	$1,050.00
FV	$1,000.00	I/YR	2.64%
PV = Price	$1,213.55	Nom. YTC	5.27%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-6

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Yields to maturity and call KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

A 25-year, $1,000 par value bond has an 8.5% annual coupon. The bond currently sells for $875. If the yield to maturity remains at its current rate, what will the price be 5 years from now?

a.	$839.31
b.	$860.83
c.	$882.90
d.	$904.97
e.	$927.60

ANS: C

First find the YTM at this time, then use the YTM with the other data to find the bond’s price 5 years hence.

Par value	$1,000
Coupon rate	8.50%	Value in 5 years
N	25	N	20
PV	$875	I/YR	9.86%
PMT	$85	PMT	$85
FV	$1,000	FV	$1,000
I/YR	9.86%	PV	$882.90

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-4

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond value in future time periods KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

McCurdy Co.’s Class Q bonds have a 12-year maturity, $1,000 par value, and a 5.75% coupon paid semiannually (2.875% each 6 months), and those bonds sell at their par value. McCurdy’s Class P bonds have the same risk, maturity, and par value, but the P bonds pay a 5.75% annual coupon. Neither bond is callable. At what price should the annual payment bond sell?

a.	$943.98
b.	$968.18
c.	$993.01
d.	$1,017.83
e.	$1,043.28

ANS: C

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 Bond A must sell at a price below the $1,000 par value at which S sells.

Semiannual bond		Annual bond
Par value	$1,000	Par value	$1,000
Coupon rate = Nominal rate	5.75%	Coupon rate	5.75%
Payment per period	$28.75	Pmt/Period	$57.50
Years to maturity	12	Yrs to maturity	12
Periods/year	2	Periods/year	1
Total periods	24	Total periods	12
EFF%	5.833%	EFF% = YTM	5.833%
Price	$1,000.00	Price	$993.01

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-5

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond valuation: effective rates KEY: Bloom’s: Analysis

MSC: TYPE: Multiple Choice: Problem

Reinegar Corporation is planning two new issues of 25-year bonds. Bond Par will be sold at its $1,000 par value, and it will have a 10% semiannual coupon. Bond OID will be an Original Issue Discount bond, and it will also have a 25-year maturity and a $1,000 par value, but its semiannual coupon will be only 6.25%. If both bonds are to provide investors with the same effective yield, how many of the OID bonds must Reinegar issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds.

a.	4,228
b.	4,337
c.	4,448
d.	4,562
e.	4,676

ANS: D

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%. 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 issued.

Bond A: Issued at par		Bond B: Issued at a discount (OID bonds)
Par value	$1,000	Par value	$1,000
Coupon rate	10.00%	Coupon rate	6.25%
Maturity yrs	25	Maturity yrs	25
Periods/year	2	Periods/year	2
N	50	N	50
Periodic rate	5.00%	Periodic rate	5.00%
PMT	$50.00	PMT	$31.25
PV = Price	$1,000.00	PV = Price	$657.70

Funds needed	$3,000,000
Number of bonds	4,561.34
Rounded up	4,562

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-5

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds

LOC: TBA TOP: Bond valuation: original issue discount bonds

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

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