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CHAPTER 7 BONDS AND THEIR VALUATION 1. 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 2. 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 3. 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. b. The coupon rate should be exactly equal to 6%. 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 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. 4. 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. b. c. Because of the call premium, the required rate of return would decline. There is no reason to expect a change in the required rate of return. 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 5. 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 6. 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 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. Par YTM Maturity Price Payment Coupon rate Current yield 7. $1,000 8.00% 10 $1,100 $94.90 9.49% 8.63% The current yield is greater than 8%. 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 8. Three $1,000 face value, 10-year, noncallable, bonds have the same amount of risk, hence their YTMs are equal. Bond 8 has an 8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12 has a 12% annual coupon. Bond 10 sells at par. Assuming that interest rates remain constant for the next 10 years, which of the following statements is CORRECT? Bond 8’s current yield will increase each year. 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 a. b. 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 interest rate risk. It has more default risk. 9. 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. b. c. If market interest rates decline, the price of the bond will also decline. The bond is currently selling at a price below its par value. 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 10. 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. b. The prices of both bonds will decrease by the same amount. 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 We can tell by inspection that c, d, and e are all incorrect. A is also incorrect because the 10-year bond will fall more due to its longer maturity and lower coupon. That leaves Answer b as the only possibly correct statement. Recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 10-year, 8% coupon bond should be more sensitive to a decline in rates. You could also do some calculations to confirm that b is correct. 11. 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. b. c. The price of Bond B will decrease over time, but the price of Bond A will increase over time. The prices of both bonds will remain unchanged. 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 12. 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 13. 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 14. Which of the following bonds has the greatest interest rate 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 15. 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 16. Which of the following statements is CORRECT? a. All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds. b. All else equal, long-term bonds have less interest rate price risk than short-term bonds. c. All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds. d. All else equal, short-term bonds have less reinvestment rate risk than long-term bonds. e. All else equal, long-term bonds have less reinvestment rate risk than short-term bonds. Answer: e 17. 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 interest rate price risk but more reinvestment rate 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 interest rate risk. d. 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. e. Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds. Answer: d 18. 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 rate risk is lower, other things held constant, on long-term than on short-term bonds. Answer: e 19. Which of the following statements is CORRECT? a. b. c. d. All else equal, senior debt generally has a lower yield to maturity than subordinated debt. An indenture is a bond that is less risky than a mortgage bond. The expected return on a corporate bond will generally exceed the bond's yield to maturity. 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 20. Which of the following statements is CORRECT? a. b. If a coupon bond is selling at par, its current yield equals its yield to maturity. 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 21. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? If the yield to maturity remains constant, the bond’s price one year from now will be 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 a. 22. 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 23. 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 24. Which of the following statements is CORRECT? a. b. If a bond is selling at a discount to par, its current yield will be greater than its yield to maturity. All else equal, bonds with longer maturities have less interest rate (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 interest rate (price) risk than bonds with smaller coupons. Answer: e 25. 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 r d = 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 rate and interest rate price risk. Longer-term low-coupon bonds, relative to shorter-term high-coupon bonds, are generally more exposed to reinvestment rate risk than interest rate price risk. Answer: b 26. 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 27. Which of the following statements is CORRECT? a. b. c. d. If a coupon bond is selling at par, its current yield equals its yield to maturity. If rates fall after its issue, a zero coupon bond could trade at a price above its maturity (or par) value. If rates fall rapidly, a zero coupon bond’s expected appreciation could become negative. 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 28. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Each of the bonds is noncallable, has a maturity of 10 years, and has a yield to maturity of 10%. Which of the following statements is CORRECT? If the bonds' market interest rate remains at 10%, Bond Z’s price will be lower one year from now than it is today. b. Bond X has the greatest reinvestment rate 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 a. 29. 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 interest rate 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 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. 30. Which of the following statements is CORRECT? a. 10-year, zero coupon bonds have more reinvestment rate risk than 10-year, 10% coupon bonds. b. A 10-year, 10% coupon bond has less reinvestment rate 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 31. 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 32. Which of the following statements is CORRECT? a. b. c. If a coupon bond is selling at a premium, then the bond's current yield is zero. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is negative. If a bond is selling at a discount, the yield to call is a better measure of the expected return than the yield to maturity. d. The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A must have a higher yield to maturity than Bond B. e. If a coupon bond is selling at par, its current yield equals its yield to maturity. Answer: e 33. Which of the following statements is CORRECT? a. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of their coupon rates. b. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds. c. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds. d. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value. e. If a bond’s yield to maturity exceeds its coupon rate, the bond’s current yield must be less than its coupon rate. Answer: d 34. Which of the following statements is CORRECT? a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. c. 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. d. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. e. The yield curve can never be downward sloping. Answer: a 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. 35. Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that a. Inflation is expected to decline in the future. b. The economy is not in a recession. c. Long-term bonds are a better buy than short-term bonds. d. Maturity risk premiums could help to explain the yield curve’s upward slope. e. Long-term interest rates are more volatile than short-term rates. Answer: d 36. Which of the following statements is CORRECT? a. b. c. d. e. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. The most likely explanation for an inverted yield curve is that investors expect inflation to increase. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted. Answer: c 37. Short Corp. just issued bonds that will mature in 10 years, and Long Corp. issued bonds that will mature in 20 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 but not necessarily for corporate bonds. Under these conditions, which of the following statements is correct? 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. b. If the Treasury yield curve is downward sloping, Long’s bonds must under all conditions have the lower yield. c. 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. d. If the yield curve for Treasury securities is flat, Short’s bond must under all conditions have the same yield as Long’s bonds. e. If Long’s and Short’s bonds have the same default risk, their yields must under all conditions be equal. Answer: a a. 38. Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon. Both bonds have the same maturity, a face value of $1,000, an 8% yield to maturity, and are noncallable. Which of the following statements is CORRECT? a. b. Bond A’s capital gains yield is greater than Bond B’s capital gains yield. Bond A trades at a discount, whereas Bond B trades at a premium. If the yield to maturity for both bonds remains at 8%, Bond A’s price one year from now will be higher than it is today, but Bond B’s price one year from now will be lower than it is today. d. If the yield to maturity for both bonds immediately decreases to 6%, Bond A’s bond will have a larger percentage increase in value. e. Bond A’s current yield is greater than that of Bond B. Answer: e c. 39. Which of the following statements is CORRECT? a. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate. b. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond. c. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used. d. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate. e. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond. Answer: a a is correct because, with the current market rate below the coupon bond, both bonds will sell at a premium, but the premium will be larger for the noncallable bond. The same logic explains why d is false. 40. Which of the following statements is CORRECT? a. Senior debt is debt that has been more recently issued, and in bankruptcy it is paid off after junior debt because the junior debt was issued first. b. A company's subordinated debt has less default risk than its senior debt. c. Convertible bonds generally have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains. d. Junk bonds typically provide a lower yield to maturity than investment-grade bonds. e. A debenture is a secured bond that is backed by some or all of the firm’s fixed assets. Answer: c 41. Which of the following statements is CORRECT? a. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the use of debt until the bonds mature. b. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond. c. Once a firm declares bankruptcy, it must be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and legal fees. d. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds. e. A firm with a sinking fund that gives it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate. Answer: d 42. Which of the following statements is CORRECT? a. b. The total return on a bond during a given year is based only on the coupon interest payments received. All else equal, a bond that has a coupon rate of 10% will sell at a discount if the required return for bonds of similar risk is 8%. c. The price of a discount bond will increase over time, assuming that the bond’s yield to maturity remains constant. d. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds. e. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized. Answer: c 43. Which of the following statements is CORRECT? a. b. All else equal, secured debt is more risky than unsecured debt. 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 44. Grossnickle Corporation issued 20-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000 one year ago. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 19 years to maturity? a. $1,113.48 b. $1,142.03 c. $1,171.32 d. $1,201.35 e. $1,232.15 Answer: e Par value = Maturity value = FV $1,000 Coupon rate 7.5% Years to maturity = N 19 Required rate = I/YR 5.5% (Coupon rate)(Par value) = PMT $75 PV $1,232.15 45. A 25-year, $1,000 par value bond has an 8.5% annual payment coupon. The bond currently sells for $925. If the yield to maturity remains at its current rate, what will the price be 5 years from now? a. $884.19 b. $906.86 c. $930.11 d. $953.36 e. $977.20 Answer: 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 Coupon rate N $1,000 8.50% 25 Value in 5 years: N 20 PV PMT FV I/YR 46. $925 $85 $1,000 9.28% I/YR PMT FV PV 9.28% $85 $1,000 $930.11 Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 6.20%, based on semiannual compounding. What is the bond’s price? a. $1,047.19 b. $1,074.05 c. $1,101.58 d. $1,129.12 e. $1,157.35 Answer: c Par value = FV Coupon rate Periods/year Yrs to maturity Periods = Years × 2 = N Going annual rate = YTM = rd Periodic rate = rd/2 = I/YR Coupon rate × Par/2 = PMT PV 47. $1,000 7.25% 2 15 30 6.20% 3.10% $36.25 $1,101.58 In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures from historical book values to market values. KJM Corporation's balance sheet (book values) as of today is as follows: Long-term debt (bonds, at par) Preferred stock Common stock ($10 par) Retained earnings Total debt and equity $23,500,000 2,000,000 10,000,000 4,000,000 $39,500,000 The bonds have a 7.0% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 11%, so the bonds now sell below par. What is the current market value of the firm's debt? a. $17,436,237 b. $17,883,320 c. $18,330,403 d. $7,706,000 e. $7,898,650 Answer: b Calculate the price of each bond: Coupon rate Par value = FV Yrs to maturity Periods/Yr Periods = Years × 2 = N Going annual rate = rd = YTM Periodic rate = rd/2 = I/YR 7.0% $1,000 10 2 20 11.0% 5.5% Coupon rate × Par/2 = PMT Price of the bonds = PV $35.00 $760.99 Determine the number of bonds: Book value on balance sheet Par value Number of bonds = Book value/Par value $23,500,000 $1,000 23,500 Calculate the market value of bonds: Mkt value = PV × Number of bonds = $17,883,320