Chapter 07: Bonds and Their Valuation
1. If a firm raises capital by selling new bonds, it could be called the “issuing firm,” and the coupon rate is generally set
equal to the required rate on bonds of equal risk.
a.
True
b.
False
True
EASY
2. A call provision gives bondholders the right to demand, or “call for,” repayment of a bond. Typically, companies call
bonds if interest rates rise and do not call them if interest rates decline.
a.
True
b.
False
False
EASY
3. Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis
prior to their final maturity. Many indentures allow the company to acquire bonds for sinking fund purposes by either (1)
purchasing bonds on the open market at the going market price or (2) selecting the bonds to be called by a lottery
administered by the trustee, in which case the price paid is the bond’s face value.
a.
True
b.
False
True
EASY
Chapter 07: Bonds and Their Valuation
4. A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at par. These bonds provide
compensation to investors in the form of capital appreciation.
a.
True
b.
False
False
EASY
5. The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early
1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of
outstanding bonds.
a.
True
b.
False
True
EASY
6. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a
profit, may be estimated by determining future cash flows and then discounting them back to the present.
a.
True
b.
False
True
EASY
Chapter 07: Bonds and Their Valuation
7. The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond’s remaining
maturity.
a.
True
b.
False
True
EASY
8. A bond that had a 20-year original maturity with 1 year left to maturity has more price risk than a 10-year original
maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and
they cannot be called.)
a.
True
b.
False
False
EASY
9. Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally
be subject to much more price risk if you purchased a 30-day bond than if you bought a 30–year bond.
a.
True
Chapter 07: Bonds and Their Valuation
b.
False
False
EASY
10. As a general rule, a company’s debentures have higher required interest rates than its mortgage bonds because
mortgage bonds are backed by specific assets while debentures are unsecured.
a.
True
b.
False
True
EASY
11. Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers,
and to provide financing to companies of questionable financial strength.
a.
True
b.
False
True
EASY
Chapter 07: Bonds and Their Valuation
12. There is an inverse relationship between bonds’ quality ratings and their required rates of return. Thus, the required
return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower.
a.
True
b.
False
EASY
13. Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities
cannot bankrupt a company, and this makes them safer from an investor’s perspective than regular bonds.
a.
True
b.
False
False
MODERATE
14. You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment-grade
rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both
are offered to you at their $1,000 par values. However, Bond SF has a sinking fund while Bond NSF does not. Under the
sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward
sloping. The bond’s prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would
generally be expected to have a higher yield than Bond NSF.
a.
True
b.
False
False
MODERATE
Chapter 07: Bonds and Their Valuation
15. Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floating-
rate debt shifts price risk to companies, it offers no advantages to corporate issuers.
a.
True
b.
False
False
MODERATE
16. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and
is not expected to default. The bond should sell at a premium if market interest rates are below 10% and at a discount if
interest rates are greater than 10%.
a.
True
b.
False
17. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper
FOFM.BRIG.17.07.02 – Key Characteristics of Bonds
Chapter 07: Bonds and Their Valuation
that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10
years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on
bonds with this risk is 12%.
a.
True
b.
False
MODERATE
18. If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then
the market value of the bond will always be below its par value until the bond matures, at which time its market value will
equal its par value. (Accrued interest between interest payment dates should not be considered when answering this
question.)
a.
True
b.
False
True
MODERATE
19. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds,
other things held constant.
a.
True
b.
False
True
Chapter 07: Bonds and Their Valuation
20. Restrictive covenants are designed primarily to protect bondholders by constraining the actions of managers. Such
covenants are spelled out in bond indentures.
a.
True
b.
False
True
MODERATE
7-8 Default Risk
True / False
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Restrictive covenants
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21. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second
mortgage bonds.
a.
True
b.
False
True
MODERATE
7-8 Default Risk
True / False
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Bonds and debentures
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22. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield
curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical
MODERATE
7-5 Changes in Bond Values over Time
True / False
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Chapter 07: Bonds and Their Valuation
noncallable bond.
a.
True
b.
False
False
CHALLENGING
7-4 Bond Yields
True / False
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Callable bonds
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23. Which of the following statements is CORRECT?
a.
You hold two bonds, a 10-year, zero coupon, issue and a 10-year bond that pays a 6% annual coupon. The
same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon
bond will experience the larger percentage decline.
b.
The time to maturity does not affect the change in the value of a bond in response to a given change in interest
rates.
c.
You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond that pays a 6%
annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current
level, the zero coupon bond will experience the smaller percentage decline.
d.
The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in
interest rates, other things held constant.
e.
The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in
interest rates.
24. Which of the following events would make it more likely that a company would call its outstanding callable bonds?
a.
The company’s bonds are downgraded.
b.
Market interest rates rise sharply.
Chapter 07: Bonds and Their Valuation
c.
Market interest rates decline sharply.
d.
The company’s financial situation deteriorates significantly.
e.
Inflation increases significantly.
25. Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable,
are as follows:
T-bond = 7.72% A = 9.64%
AAA = 8.72% BBB = 10.18%
The differences in rates among these issues were most probably caused primarily by:
a.
Real risk-free rate differences.
b.
Tax effects.
c.
Default risk and liquidity differences.
d.
Maturity risk differences.
e.
Inflation differences.
26. Under normal conditions, which of the following would be most likely to increase the coupon rate required for a bond
to be issued at par?
a.
Adding additional restrictive covenants that limit management’s actions.
b.
Adding a call provision.
c.
The rating agencies change the bond’s rating from Baa to Aaa.
d.
Making the bond a first mortgage bond rather than a debenture.
e.
Adding a sinking fund.
Chapter 07: Bonds and Their Valuation
27. Which of the following statements is CORRECT?
a.
Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if
interest rates decline after the bond was issued.
b.
Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be
available to pay off bondholders when the bonds mature.
c.
A sinking fund provision makes a bond more risky to investors at the time of issuance.
d.
Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the
company to reduce its debt over time.
e.
If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely
to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the
sinking fund call price.
28. Amram Inc. can issue a 20-year bond with a 6% annual coupon at par. This bond is not convertible, not callable, and
has no sinking fund. Alternatively, Amram could issue a 20-year bond that is convertible into common equity, may be
called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Amram would have
to pay on the second bond, the convertible, callable bond with the sinking fund, to have it sell initially at par?
a.
The coupon rate should be exactly equal to 6%.
b.
The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the
real world the convertible feature would probably cause the coupon rate to be less than 6%.
c.
The rate should be slightly greater than 6%.
d.
The rate should be over 7%.
e.
The rate should be over 8%.
Chapter 07: Bonds and Their Valuation
7-2 Key Characteristics of Bonds
Multiple Choice
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Convertible, callable bonds
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29. Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but
this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their
required rate of return?
a.
Because of the call premium, the required rate of return would decline.
b.
There is no reason to expect a change in the required rate of return.
c.
The required rate of return would decline because the bond would then be less risky to a bondholder.
d.
The required rate of return would increase because the bond would then be more risky to a bondholder.
e.
It is impossible to say without more information.
30. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the
following statements is CORRECT?
a.
The bond’s expected capital gains yield is zero.
b.
The bond’s yield to maturity is above 9%.
c.
The bond’s current yield is above 9%.
d.
If the bond’s yield to maturity declines, the bond will sell at a discount.
e.
The bond’s current yield is less than its expected capital gains yield.
Chapter 07: Bonds and Their Valuation
31. Which of the following statements is CORRECT?
a.
A zero coupon bond’s current yield is equal to its yield to maturity.
b.
If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at par.
c.
All else equal, if a bond’s yield to maturity increases, its price will fall.
d.
If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at a premium over par.
e.
All else equal, if a bond’s yield to maturity increases, its current yield will fall.
32. A 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT?
a.
The bond’s coupon rate exceeds its current yield.
b.
The bond’s current yield exceeds its yield to maturity.
c.
The bond’s yield to maturity is greater than its coupon rate.
d.
The bond’s current yield is equal to its coupon rate.
e.
If the yield to maturity stays constant until the bond matures, the bond’s price will remain at $850.
7-4 Bond Yields
Multiple Choice
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Chapter 07: Bonds and Their Valuation
33. Which of the following statements is CORRECT?
a.
If a bond is selling at a discount, the yield to call is a better measure of return than is the yield to maturity.
b.
On an expected yield basis, the expected capital gains yield will always be positive because an investor would
not purchase a bond with an expected capital loss.
c.
On an expected yield basis, the expected current yield will always be positive because an investor would not
purchase a bond that is not expected to pay any cash coupon interest.
d.
If a coupon bond is selling at par, its current yield equals its yield to maturity, and its expected capital gains
yield is zero.
e.
The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield
to maturity than Bond B.
34. Three $1,000 face value, 10-year, noncallable, bonds have the same amount of risk, hence their YTMs are equal. Bond
8 has an 8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12 has a 12% annual coupon. Bond 10 sells at
par. Assuming that interest rates remain constant for the next 10 years, which of the following statements is CORRECT?
a.
Bond 8’s current yield will increase each year.
b.
Since the bonds have the same YTM, they should all have the same price, and since interest rates are not
expected to change, their prices should all remain at their current levels until maturity.
c.
Bond 12 sells at a premium (its price is greater than par), and its price is expected to increase over the next
year.
d.
Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year.
e.
Over the next year, Bond 8’s price is expected to decrease, Bond 10’s price is expected to stay the same, and
Bond 12’s price is expected to increase.
less price risk. It has more default risk).
7-5 Changes in Bond Values over Time
Multiple Choice
FOFM.BRIG.17.07.05 – Changes in Bond Values Over Time
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Chapter 07: Bonds and Their Valuation
35. A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following
statements is CORRECT?
a.
The bond’s current yield is less than 8%.
b.
If the yield to maturity remains at 8%, then the bond’s price will decline over the next year.
c.
The bond’s coupon rate is less than 8%.
d.
If the yield to maturity increases, then the bond’s price will increase.
e.
If the yield to maturity remains at 8%, then the bond’s price will remain constant over the next year.
10 years
Coupon rate
Current yield
7-5 Changes in Bond Values over Time
Multiple Choice
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Int. rates and bond prices
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36. A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has
a yield to maturity of 7%. Which of the following statements is CORRECT?
a.
If market interest rates decline, the price of the bond will also decline.
b.
The bond is currently selling at a price below its par value.
c.
If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today.
d.
The bond should currently be selling at its par value.
e.
If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.
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Bond values over time
Bloom’s: Application
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Chapter 07: Bonds and Their Valuation
37. A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Neither is callable, and
both have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the
following statements would be CORRECT?
a.
The prices of both bonds will decrease by the same amount.
b.
Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.
c.
The prices of both bonds would increase by the same amount.
d.
One bond’s price would increase, while the other bond’s price would decrease.
e.
The prices of the two bonds would remain constant.
7-5 Changes in Bond Values over Time
Multiple Choice
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38. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds
have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is
CORRECT?
a.
The price of Bond B will decrease over time, but the price of Bond A will increase over time.
b.
The prices of both bonds will remain unchanged.
c.
The price of Bond A will decrease over time, but the price of Bond B will increase over time.
d.
The prices of both bonds will increase by 7% per year.
e.
The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.
7-5 Changes in Bond Values over Time
Multiple Choice
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Chapter 07: Bonds and Their Valuation
39. Which of the following bonds would have the greatest percentage increase in value if all interest rates in the economy
fall by 1%?
a.
10-year, zero coupon bond.
b.
20-year, 10% coupon bond.
c.
20-year, 5% coupon bond.
d.
1-year, 10% coupon bond.
e.
20-year, zero coupon bond.
40. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the
largest percentage increase in price?
a.
An 8-year bond with a 9% coupon.
b.
A 1-year bond with a 15% coupon.
c.
A 3-year bond with a 10% coupon.
d.
A 10-year zero coupon bond.
e.
A 10-year bond with a 10% coupon.
7-5 Changes in Bond Values over Time
Multiple Choice
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Bloom’s: Analysis
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Chapter 07: Bonds and Their Valuation
41. Which of the following bonds has the greatest price risk?
a.
A 10-year $100 annuity.
b.
A 10-year, $1,000 face value, zero coupon bond.
c.
A 10-year, $1,000 face value, 10% coupon bond with annual interest payments.
d.
All 10-year bonds have the same price risk since they have the same maturity.
e.
A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.
42. If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in
value?
a.
A 1-year zero coupon bond.
b.
A 1-year bond with an 8% coupon.
c.
A 10-year bond with an 8% coupon.
d.
A 10-year bond with a 12% coupon.
e.
A 10-year zero coupon bond.
43. Which of the following statements is CORRECT?
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Price risk
Bloom’s: Analysis
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Chapter 07: Bonds and Their Valuation
a.
All else equal, high-coupon bonds have less reinvestment risk than low-coupon bonds.
b.
All else equal, long-term bonds have less price risk than short-term bonds.
c.
All else equal, low-coupon bonds have less price risk than high-coupon bonds.
d.
All else equal, short-term bonds have less reinvestment risk than long-term bonds.
e.
All else equal, long-term bonds have less reinvestment risk than short-term bonds.
44. Which of the following statements is CORRECT?
a.
One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it
until it matures or is sold.
b.
Long-term bonds have less price risk but more reinvestment risk than short-term bonds.
c.
If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less
price risk.
d.
Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more price risk but less
reinvestment risk.
e.
Long-term bonds have less price risk and also less reinvestment risk than short-term bonds.
45. Which of the following statements is CORRECT?
a.
All else equal, secured debt is more risky than unsecured debt.
b.
The expected return on a corporate bond must be greater than its promised return if the probability of default is
greater than zero.
c.
All else equal, senior debt has more default risk than subordinated debt.
d.
A company’s bond rating is affected by its financial ratios but not by provisions in its indenture.
Chapter 07: Bonds and Their Valuation
e.
Under Chapter 7 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.
46. Which of the following statements is CORRECT?
a.
If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield
curve for U.S. Treasury securities would, other things held constant, have an upward slope.
b.
Liquidity premiums are generally higher on Treasury than corporate bonds.
c.
The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact
that the probability of default is higher on long-term bonds than on short-term bonds.
d.
Default risk premiums are generally lower on corporate than on Treasury bonds.
e.
Reinvestment risk is lower, other things held constant, on long-term than on short-term bonds.
Multiple Choice
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Term structure
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47. Which of the following statements is CORRECT?
a.
All else equal, senior debt generally has a lower yield to maturity than subordinated debt.
b.
An indenture is a bond that is less risky than a mortgage bond.
c.
The expected return on a corporate bond will generally exceed the bond’s yield to maturity.
d.
If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors will also exceed its
yield to maturity.
e.
Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then
be liquidated.