Principles of Managerial Finance, Brief, 7e (Gitman)
Chapter 6 Interest Rates and Bond Valuation
6.1 Describe interest rate fundamentals, the term structure of interest rates, and risk premiums.
1) An interest rate or a required rate of return represents the cost of money.
2) Longer the maturity of a Treasury security, the smaller the interest rate risk.
3) A real rate of interest is the compensation paid by the borrower of funds to the lender.
4) A nominal rate of interest is equal to the sum of the real rate of interest plus the risk free rate
of interest.
5) Risk-free rate of interest is equal to the sum of the real rate of interest plus an inflation
premium.
6) Nominal rate of interest is equal to the sum of the real rate of interest plus an inflation
premium plus a risk premium.
7) The nominal rate of interest on a bond is 7% and an inflation premium of 3%. This results in a
real rate of interest of 4% on the bond.
8) In theory, the rate of return on U.S. Treasury bills should always exceed the rate of inflation as
measured by the consumer price index.
9) The nominal rate of interest is the actual rate of interest charged by the supplier of funds and
paid by demander.
10) The term structure of interest rates is a graphical presentation of the relationship between the
maturity and rate of return.
11) An inverted yield curve is a downward-sloping yield curve that indicates that short-term
interest rates are generally higher than long-term interest rates.
12) A yield curve that reflects relatively similar borrowing costs for both short- and long-term
loans is called a normal yield curve.
13) Upward-sloping yield curves result from higher future inflation expectations, lender
preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term
loans relative to their respective demand.
14) A flat yield curve means that the rates do not vary much at different maturities.
15) A normal yield curve is upward-sloping and indicates generally cheaper short-term
borrowing costs than long-term borrowing costs.
16) A flat yield curve indicates generally cheaper long-term borrowing costs than short-term
borrowing costs.
17) The market segmentation theory suggests that the shape of the yield curve is determined by
the supply and demand for funds within each maturity segment.
18) The liquidity preference theory suggests that the shape of the yield curve is determined by
the supply and demand for funds within each maturity segment.
19) The liquidity preference theory suggests that short-term interest rates should be lower than
long-term interest rates.
20) The expectations theory suggests that the shape of the yield curve reflects investors
expectations about future interest rates.
21) A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than
long-term borrowing costs.
22) An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper
short-term borrowing costs than long-term borrowing costs.
23) The liquidity preference theory suggests that for any given issuer, long-term interest rates
tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to
general interest rate movements of longer-term securities; this causes the yield curve to be
upward-sloping.
24) The components of risk premium includes business risk, financial risk, interest rate risk,
liquidity risk, and tax risk.
25) The reason for a difference in the yield between a Aaa corporate bond and an otherwise
identical Baa bond is the risk premium; other things being equal.
26) The possibility that the issuer of a bond will not pay the contractual interest or principal
payments as scheduled is called maturity risk.
27) The possibility that the issuer of a bond will not pay the contractual interest or principal
payments as scheduled is called default risk.
28) ________ rate of interest creates equilibrium between the supply of savings and the demand
for investment funds.
A) Nominal
B) Real
C) Risk-free
D) Inflationary
29) Generally, an increase in risk will result in ________.
A) a lower required return or interest rate
B) a higher required return or interest rate
C) a higher return on investment
D) a lower return on investment
30) Nominal rate of interest is equal to ________.
A) the real rate plus an inflationary expectation
B) the real rate plus a risk premium
C) the risk-free rate plus an inflationary expectation
D) the risk-free rate plus a risk premium
31) The ________ rate is typically the nominal rate of interest on a three-month U.S. Treasury
bill.
A) expected
B) real
C) risk-free
D) premium
32) Nico Nelson, a management trainee at a large New York-based bank, is trying to estimate the
real rate of return expected by investors. He notes that the 3-month T-bill currently yields 3
percent and has decided to use the consumer price index as a proxy for expected inflation. What
is the estimated real rate of interest if the CPI is currently 2 percent?
A) 5%
B) 1%
C) 3%
D) 2%
33) The inflation risk premium on a bond is 2 percent, the U.S. T-bill rate is 5 percent, the
maturity risk premium on the bond is 3 percent, the default risk premium on the bond is 2
percent, and the liquidity risk premium on the bond is 1 percent. Calculate its nominal rate of
return.
A) 16%
B) 13%
C) 11%
D) 9%
34) Nico invested an amount a year ago and calculated his return on investment. He found that
his purchasing power had increased by 15 percent as a result of his investment. If inflation
during the year was 4 percent, then Nico’s ________.
A) real return on investment is more than 15 percent
B) nominal return on investment is more than 15 percent
C) nominal return on investment is less than 11 percent
D) real return on investment is equal to 4 percent
35) ________ rate of interest is the actual rate charged by the supplier and paid by the demander
of funds.
A) Nominal
B) Real
C) Risk-free
D) Inflationary
36) The ________ is the compound annual rate of interest earned on a debt security purchased on
a given date and held to maturity.
A) risk premium
B) yield curve
C) risk-free rate
D) yield to maturity
37) A(n) ________ is a graphic depiction between the maturity and rate of return for bonds with
similar risks.
A) yield curve
B) supply function
C) risk-return profile
D) aggregate demand curve
38) A(n) ________ yield curve reflects higher expected future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
39) A(n) ________ yield curve reflects lower expected future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
40) The term structure of interest rates is the relationship between ________.
A) the present value of principal and coupon rate of the bonds
B) the general expectation of inflation and nominal rate of return for bonds
C) the general expectation of inflation and real rate of return for bonds
D) the maturity and rate of return for bonds with similar level of risk
41) A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs
than short-term borrowing costs is called ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) linear yield curve
42) An upward-sloping yield curve that indicates cheaper short-term borrowing costs than long-
term borrowing costs is called as ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal yield curve
43) A yield curve that reflects relatively similar borrowing costs for both short-term and long-
term loans is called as ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal curve
44) The theory suggesting that for any given issuer, long-term interest rates tends to be higher
than short-term rates is called ________.
A) expectation hypothesis
B) liquidity preference theory
C) market segmentation theory
D) interest parity theory
45) The yield curve in an economic period where higher future inflation is expected would be
________.
A) upward-sloping
B) flat
C) downward-sloping
D) lognormal
46) The yield curve in an economic period where lower future inflation is expected would be
________.
A) upward-sloping
B) flat
C) downward-sloping
D) exponential
47) Which of the following explains the general shape of the yield curve of a bond?
A) Expectations theory
B) Perfect market theory
C) Capital asset pricing theory
D) Securities market theory
48) Assume the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM
common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based
on this information, the shape of the yield curve is ________.
A) upward sloping
B) downward sloping
C) flat
D) normal
49) ________ mainly explains the tendency for the yield curve to be upward sloping.
A) Expectations theory
B) Liquidity preference theory
C) Market segmentation theory
D) Investor perception theory
50) Which of the following affects the slope of yield curve?
A) tax rates
B) dividend policy
C) selection of accounting standards
D) liquidity preferences
51) Which of the following is true of risk premium?
A) T-bills have a have a higher risk premium than that of Treasury bonds.
B) The government bonds have a higher risk premium than that of corporate bonds.
C) The speculative corporate issues have a lower risk premium than that of the higher rated
corporate issues.
D) The lower-rated corporate issues have a higher risk premium than that of the higher rated
corporate issues.
52) Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.
53) Explain liquidity, default risk, and maturity risk premiums.
6.2 Review the legal aspects of bond financing and bond cost.
1) Coupon interest rate on a bond represents the percentage of the bond’s par value that will be
paid annually, typically in two equal semiannual payments, as interest.
2) Restrictive covenants are contractual clauses in long-term debt agreements that place certain
operating and financial constraints on the borrower.
3) Standard debt provisions specify certain record keeping and general business practices that
must be ensured by the bond issuer.
4) A trustee is a paid party representing the bond issuer in the bond indenture.
5) Restrictive covenants, coupled with standard debt provisions, help the lender to monitor the
borrower’s activities to ensure efficient use of funds.
6) The restrictive debt covenant that imposes fixed assets is to guarantee fixed-payment
obligations by maintaining a specified level of fixed assets.
7) In a bond indenture, subordination is the stipulation that subsequent creditors agree to wait
until all claims of the senior debt are satisfied.
8) The bond indenture identifies any collateral pledged against a bond and specifies how it is to
be maintained.
9) To carry out systematic retirement of bonds, a corporation makes semiannual or annual
payments that are used to retire bonds by purchasing them in the marketplace.
10) Subordination means that subsequent creditors agree to wait until all claims of the senior
debt are satisfied.
11) Restrictive covenants place operating and financial constraints on the borrower.
12) In a bond indenture, the term “security interest” refers to the fact that most firms that issue
bonds are required to establish sinking fund provisions to protect bondholders.
13) In a bond indenture, the term “security interest” refers to collateral pledged against the bond.
14) Longer the maturity, higher is the cost of a bond.
15) The lower a bond’s default risk, the higher is the interest rate.
16) The legal contract setting forth the terms and provisions of a corporate bond is a(n)
________.
A) indenture
B) debenture
C) loan document
D) promissory note
17) A debt instrument indicating that a corporation has borrowed a certain amount of money and
promises to repay it in the future under clearly defined terms is called a(n) ________.
A) common stock
B) corporate bond
C) indenture
D) preferred stock
18) A(n) ________ is a paid individual, corporation, or a commercial bank trust department that
acts as a third party to a bond indenture.
A) trustee
B) investment banker
C) bond issuer
D) bond rating agency