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Chapter 04: Bond Valuation
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NATIONAL STANDARDS:
United States - BUSPROG: Reflective Thinking
69. 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.
ANSWER:
a
70. 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
ANSWER:
e
71. 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.
ANSWER:
b
72. 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%
POINTS:
1
73. 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%
POINTS:
1
74. 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%
ANSWER:
e
Chapter 04: Bond Valuation
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POINTS:
1
75. 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.)
a.
True
b.
False
ANSWER:
False
76. 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.
a.
True
Chapter 04: Bond Valuation
b.
False
ANSWER:
False
77. 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
ANSWER:
True
78. 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.
ANSWER:
d
79. 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.
ANSWER:
c
80. 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.
ANSWER:
a
81. 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.
ANSWER:
d
82. 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.
ANSWER:
d
83. 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.
ANSWER:
c
84. 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.
ANSWER:
d
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85. 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 rd = 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 rd = YTM = 5%, the bond would sell at a premium over its
$1,000 par value.
ANSWER:
a
86. 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.
Chapter 04: Bond Valuation
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.
ANSWER:
e
87. 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.
ANSWER:
c
88. 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.
ANSWER:
b
89. 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.
ANSWER:
a
90. 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 (rd) 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.
ANSWER:
d
91. 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.
ANSWER:
d
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92. 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.
ANSWER:
e
93. 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.
Chapter 04: Bond Valuation
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d.
Long-term interest rates are more volatile than short-term rates.
e.
Inflation is expected to decline in the future.
ANSWER:
c
94. 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.
ANSWER:
b
95. 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.
Chapter 04: Bond Valuation
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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.
ANSWER:
e
96. 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
ANSWER:
True
97. 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.
Chapter 04: Bond Valuation
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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.
ANSWER:
b
98. 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.
ANSWER:
e
99. 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.
Chapter 04: Bond Valuation
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.
ANSWER:
c
100. 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.
ANSWER:
b
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101. 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.
ANSWER:
d
