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Foundations of Finance, 9e (Keown/Martin/Petty)
Chapter 7 The Valuation and Characteristics of Bonds
Learning Objective 7.1
1) Subordinated debentures are more risky than unsubordinated debentures because the claims of
subordinated debenture holders are less likely to be honored in the event of liquidation.
Keywords: Subordinated Debentures, Unsubordinated Debentures, Liquidation
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
2) An example of a Eurobond is a bond issued in Asia by a U.S. Corporation with interest and principal
payments made in U.S. dollars.
Keywords: Eurobonds
Learning Obj.: L.O. 7.1
AACSB: Diverse and multicultural work environments
3) Convertible bonds decrease in value whenever the price of the company‘s stock increases.
Keywords: Convertible Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
4) Junk bonds are also called high-yield bonds.
Keywords: Junk Bonds, High–Yield Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
5) The expected yield on junk bonds is higher than the yield on AAA-rated bonds because of the higher
default risk associated with junk bonds.
Keywords: Junk Bonds, Default Risk, Bond Yields
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
6) Bonds issued in a country different from the one in which the currency of the bond is denominated are
called Eurobonds.
Keywords: Eurobonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
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7) Convertible bonds are debt securities that can be converted into a firm‘s stock at a prespecified price.
Keywords: Convertible Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
8) A mortgage bond is secured by a lien on real property.
Keywords: Mortgage Bond
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
9) A bond is a long-term promissory note issued by the firm.
Keywords: Bond, Promissory Note
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
10) Debentures are expected to have a lower yield than secured bonds because the debentures are more
risky and therefore less desirable.
Keywords: Debenture, Secured Bond
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
11) Progressive Corporation issued callable bonds. The bonds are most likely to be called if
A) interest rates decrease.
B) interest rates increase.
C) Progressive Corporation needs additional financing.
D) Progressive Corporation’s stock price increases dramatically.
Keywords: Callable Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
12) Which of the following statements concerning junk bonds is MOST correct?
A) A rational investor will always prefer a AAA-rated bond to a junk bond.
B) Junk bonds have higher interest rates than AAA-rated bonds because of the higher risk.
C) Junk bonds may also be called low-yielding securities.
D) Junk bonds are priced higher than AAA-rated bonds because junk bonds are more risky.
Keywords: Junk Bonds
Learning Obj.: L.O. 7.1
AACSB: Analytical Thinking
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13) Which of the following statements is true regarding convertible bonds?
A) The holder has the right to sell these bonds back to the issuer if the bonds don’t perform well.
B) The holder can convert these bonds into an equal number of new bonds if they choose to do so.
C) These bonds are convertible into common stock of the issuing firm at a prespecified price.
D) These bonds have a variable interest rate.
Keywords: Convertible Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
14) If a corporation were to choose between issuing a debenture, a mortgage bond, or a subordinated
debenture, which would have the highest yield to maturity, everything else equal?
A) the debenture
B) the mortgage bond
C) the subordinated debenture
D) all of the above
Keywords: Yield to Maturity, Debenture, Mortgage Bond, Subordinated Debenture
Learning Obj.: L.O. 7.1
AACSB: Analytical Thinking
15) Which of the following is true of a zero coupon bond?
A) The bond makes no coupon payments.
B) The bond sells at a premium prior to maturity.
C) The bond has a zero par value.
D) The bond has no value until the year it matures because there are no positive cash flows until then.
Keywords: Zero Coupon Bond
Learning Obj.: L.O. 7.1
AACSB: Analytical Thinking
16) If a firm were to experience financial insolvency, the legal system provides an order of hierarchy for
the payment of claims. Assume that a firm has the following outstanding securities: mortgage bonds,
common stock, debentures, and preferred stock. Rank the order in which investors that own mortgage
bonds would have their claim paid?
A) first
B) second
C) third
D) fourth
Keywords: Insolvency, Mortgage Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
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17) Put the following in order of their claim on assets of a firm, starting with the LAST to have a claim:
A. Subordinated debentures
B. Debentures (unsubordinated)
C. Common Stock
D. Preferred stock
A) C, B, A, D
B) C, D, A, B
C) B, A, C, D
D) D, C, B, A
E) D, C, A, B
Keywords: Subordinated Debentures, Debentures, Common Stock, Preferred Stock
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
18) Other things being equal, investors will value which of the following bonds the highest?
A) callable bonds
B) convertible bonds
C) bonds that are both callable and convertible
D) unsecured, callable bonds
Keywords: Convertible Bonds, Callable Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
19) Which of the following bond provisions will make a bond more desirable to investors, other things
being equal?
A) The bond is convertible.
B) The bond is callable.
C) The coupon rate is lower.
D) The bond is subordinated.
Keywords: Convertible Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
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20) If a corporation were to choose between issuing a debenture, a mortgage bond, or a subordinated
debenture, everything else equal (such as coupon rate, maturity, etc.) which would sell for the greatest
price?
A) the debenture
B) the mortgage bond
C) the subordinated debenture
D) All of the above types of bonds would sell for the same price.
Keywords: Debenture, Mortgage Bond, Subordinated Debenture
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
21) Why would a convertible bond increase much more in value than a bond that is not convertible?
Keywords: Convertible Bonds
Learning Obj.: L.O. 7.1
AACSB: Reflective Thinking
Learning Objective 7.2
1) In general, interest on bonds, like dividends on preferred stock, may be deferred until a later date at
the discretion of management, making debt financing more appealing to corporate managers.
Keywords: Interest, Dividends
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
2) Restrictive provisions in bond indenture agreements are designed to protect bondholders and lessen
the agency problems between bondholders and stockholders.
Keywords: Restrictive Covenants, Indenture Agreements, Agency Problems
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
3) A company with a AAA bond rating will command a higher interest rate on its bonds than a company
with a lesser BBB bond rating.
Keywords: Bond Rating
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
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4) Other things held equal, a bond with a call provision is worth more to investors than a bond without a
call provision.
Keywords: Call Provision
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
5) Bonds generally have a maturity date while preferred stocks do not.
Keywords: Bonds, Maturity Date, Preferred Stock
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
6) If the demand for a new bond issue increases, it is likely that the coupon rate will be adjusted upward
by the issuing company.
Keywords: Bond Value, Coupon Rates, Supply/Demand
Learning Obj.: L.O. 7.2
AACSB: Analytical Thinking
7) If a bond’s rating declines, the interest rate demanded by investors, called the required return, also
decreases.
Keywords: Bond Rating, Required Return
Learning Obj.: L.O. 7.2
AACSB: Analytical Thinking
8) In the case of insolvency, the claims of debt are honored prior to those of common stock and after those
of preferred stock.
Keywords: Insolvency, Risk
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
9) Junk bonds typically have an interest rate of between 3 and 5 percent more than AAA-rated long-term
debt.
Keywords: Junk Bonds
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
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10) A common protective provision in a bond indenture is the limitation of dividends on the issuing
firm’s common stock.
Keywords: Protective Covenants, Bond Indenture
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
11) A firm‘s bond rating would be favorably affected if they have a low use of financial leverage (debt).
Keywords: Bond Rating, Financial Leverage
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
12) A bond rating of “BB” indicates that the company’s financial position is above average and hence the
default risk on the bonds is very low.
Keywords: Bond Rating, Default Risk
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
13) Federal regulations make it impossible for rating agencies to drop a company‘s credit rating more
than two notches at a time in order to prevent panic in bond markets.
Keywords: Bond Rating
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
14) The par value of a corporate bond indicates the payment that the issuer promises to make to the
bondholder at maturity.
Keywords: Keywords: Par Value
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
15) To determine the periodic interest payments that a bond makes, multiply the bond’s stated coupon
rate by its par value and divide by the number of coupon payments per year.
Keywords: Interest, Coupon Rate, Par Value
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
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16) The Johnson Corporation issues a bond which has a coupon rate of 10.20%, a yield to maturity of
10.55%, a face value of $1,000, and a market price of $850. Therefore, the annual interest payment is
A) $101.75.
B) $102.
C) $105.50.
D) $120.0.
Keywords: Coupon Rate, Annual Interest
Learning Obj.: L.O. 7.2
AACSB: Analytical Thinking
17) Which of the following statements concerning bonds and risk is true?
A) Because the interest payments and maturing value are known, the only risk associated with investing
in bonds is default risk.
B) Zero coupon bonds are always more risky than bonds with high coupon rates because of the time
value of money.
C) Bonds are generally less risky than common stock because of the preference for debt over equity in the
event of bankruptcy and liquidation.
D) B-rated bonds are above average for risk, i.e., less risky than the average bond.
Keywords: Risk, Bond Ratings, Default Risk
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
18) Which of the following is FALSE concerning bonds?
A) The indenture spells out the obligations of the bond issuer.
B) Mortgage bonds are secured by assets such as real estate.
C) Debentures are secured by assets other than real estate.
D) Subordinated debentures are riskier than unsubordinated debentures.
Keywords: Indenture, Mortgage Bonds, Debentures, Subordinated Debentures, Unsubordinated Debentures
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
19) Speculative, or non-investment-grade, bonds have an S&P bond rating of
A) C or less.
B) CCC or less.
C) BB or less.
D) BBB or less.
Keywords: Bond Rating
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
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20) A company with a bond rating of BBB is more likely to have which of the following qualities
compared to a company with a bond rating of B?
A) greater reliance on equity financing
B) high variability in past earnings
C) little use of subordinated debt
D) small firm size
Keywords: Standard & Poor’s, Bond Ratings
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
21) You want to invest in bonds. Explain whether or not each provision listed will make the bonds more
or less desirable as an investment: call provision, convertible bond provision, subordinated debt.
Keywords: Call Provision
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
22) What restrictions are typically included in an indenture of bonds in order to protect the bondholder?
Keywords: Restrictive Covenants, Indenture Agreements, Agency Problems
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
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23) How does the bond rating affect an investor‘s required rate of return? What factors affect a bond’s
rating?
Keywords: Bond Rating
Learning Obj.: L.O. 7.2
AACSB: Reflective Thinking
Learning Objective 7.3
1) Unlike market value, the intrinsic value of an asset is estimated independently of risk.
Keywords: Intrinsic Value, Risk
Learning Obj.: L.O. 7.3
AACSB: Reflective Thinking
2) The sum of the present values of an investment’s expected future cash flows is known as the
investment’s intrinsic value.
Keywords: Intrinsic Value
Learning Obj.: L.O. 7.3
AACSB: Reflective Thinking
3) In an efficient market, the market value and intrinsic value of a security should be equal.
Keywords: Intrinsic Value
Learning Obj.: L.O. 7.3
AACSB: Reflective Thinking
4) As market rates of interest rise, investors move their funds into bonds, thus increasing their price and
lowering their yield.
Keywords: Bond Value, Interest Rates
Learning Obj.: L.O. 7.3
AACSB: Reflective Thinking