Principles of Managerial Finance, 15e (Zutter)
Chapter 6 Interest Rates and Bond Valuation
6.1 Interest rates and required returns
1) An interest rate or a required rate of return represents the cost of money.
2) A real rate of interest is the compensation paid by the borrower of funds to the lender measured in
today’s dollars.
3) A nominal rate of interest is approximately equal to the sum of the real rate of interest plus the risk free
rate of interest.
4) The nominal interest rate on a risk-free investment is approximately equal to the sum of the real rate of
interest plus an inflation premium.
5) The nominal interest rate on a risky investment equals the risk-free rate plus a risk premium.
6) The nominal rate of interest on a bond is 8% and the expected inflation premium is 4%. This results in
an approximate real rate of interest of 4% on the bond.
7) Historically, the rate of return on U.S. Treasury bills is usually greater than the rate of inflation.
8) The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by
demander.
9) The term structure of interest rates is a graphical presentation of the relationship between the maturity
and rate of return.
10) 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.
11) A yield curve that reflects relatively similar borrowing costs for both short– and long-term loans is
called a normal yield curve.
12) 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.
13) A flat yield curve means that the rates do not vary much at different maturities.
14) A normal yield curve is upward-sloping and indicates generally cheaper short-term borrowing costs
than long-term borrowing costs.
15) A flat yield curve indicates generally cheaper long–term borrowing costs than short-term borrowing
costs.
16) 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.
17) 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.
18) The liquidity preference theory suggests that short-term interest rates should be lower than long-term
interest rates most of the time.
19) The expectations theory suggests that the shape of the yield curve reflects investors expectations
about future interest rates.
20) A downward-sloping yield curve indicates generally cheaper short–term borrowing costs than long–
term borrowing costs.
21) An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper short–term
borrowing costs than long-term borrowing costs.
22) The liquidity preference theory suggests that long-term interest rates tend to be higher than short–
term rates (and therefore the yield curve slopes up) due to the lower liquidity and higher responsiveness
to general interest rate movements of longer-term securities.
23) The components of risk premium includes business risk, financial risk, interest rate risk, liquidity risk,
and tax risk.
24) The possibility that the issuer of a bond will not pay the contractual interest or principal payments as
scheduled is called maturity risk.
25) The possibility that the issuer of a bond will not pay the contractual interest or principal payments as
scheduled is called default risk.
26) The ________ rate of interest is the rate that balances the supply of savings and the demand for
investment funds.
A) Nominal
B) Real
C) Risk-free
D) Equilibrium
27) 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 inflation premium
D) a lower real interest rate
28) Although no investment is truly risk free, ________ are generally viewed as the closest thing we can
come to in the real world to a risk-free investment.
A) U.S. Treasury securities
B) AAA-rated corporate bonds
C) secured bonds
D) zero-coupon bonds
29) Ai Lun, 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 consumer
prices have been rising steadily at a 2% rate for several years. What should Ai Lun’s estimate of the real
rate be?
A) 5%
B) 1%
C) 3%
D) 2%
30) 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
31) The ________ 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
32) 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
33) A(n) ________ is a graphic depiction of the relation 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
34) According to the expectations hypothesis, a(n) ________ yield curve reflects higher expected future
rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
35) According to the expectations hypothesis, a(n) ________ yield curve reflects lower expected future
rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
36) 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
37) 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
38) 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
39) 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
40) 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
41) Which of the following explains the general shape of the yield curve?
A) Expectations theory
B) Perfect market theory
C) Capital asset pricing theory
D) Securities market theory
42) 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
43) ________ 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
44) Which of the following affects the slope of yield curve?
A) tax rates
B) dividend policy
C) selection of accounting standards
D) liquidity preferences
45) Which of the following is true of the risk premium?
A) T-bills have a have a higher risk premium compared with Treasury bonds.
B) Government bonds have a higher risk premium compared with corporate bonds.
C) Junk bonds have a lower risk premium investment-grade bonds.
D) The lower-rated corporate issues have a higher risk premium than that of the higher rated corporate
issues.
46) Current interest rates on bonds of different maturities look like this:
Maturity Rate
1-year 2.50%
2-year 2.75%
3-year 3.00%
If the expectations hypothesis is true, what interest rate would you expect a 1–year bond to pay, 2 years
from now?
13
47) Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.
48) Current interest rates on bonds of different maturities look like this:
Maturity Rate
1-year 2.50%
2-year 2.75%
3-year 3.00%
If the expectations hypothesis is true, what interest rate would you expect a 2–year bond to pay, 1 year
from now?
49) Suppose the expectations hypothesis is true. The interest rate on a bond maturing in one year is 2%,
and the interest rate on a bond maturing in two years is 3%. The interest rate that investors expect next
year on a one-year bond is ________.
A) 2%
B) 3%
C) 4%
D) 5%
50) Jeff is trying to forecast what the annual interest rate on a three-year bond will be two years from
now, and he believes that the expectations hypothesis is the basis upon which he should build his
forecast. Currently the rates of return on bonds of different maturities look like this:
Maturity Rate
1-year 3.00%
2-year 3.50%
3-year 3.75%
4-year 4.00%
5-year 4.00%
Based on the expectations hypothesis, what forecast should Jeff make for the return on a three-year bond,
two years in the future?
A) 4.0%
B) 4.25%
C) 4.33%
D) 13%
51) Suppose the expectations hypothesis is true. The current rate of return on a one-year bond is 3%, and
the current rate of return on a 2-year bond is 2.5%. What is the expected rate of return next year on a one–
year bond?
A) 2%
B) 0.5%
C) 1.5%
D) 1%
52) Suppose the expectations hypothesis is true. If the yield curve is flat this means that ________.
A) investors do not expect interest rates to change in the future
B) investors expect interest rates to rise in the future
C) investors expect interest rates to fall in the future
D) investors do not require a premium for expected inflation
53) Explain liquidity risk, default risk, and interest rate risk.
6.2 Government and corporate bonds
1) The coupon 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) 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.
4) Standard debt provisions specify certain record keeping and general business practices that must be
followed by the bond issuer.
5) A trustee is a paid party representing the bond issuer in the bond indenture.
6) Restrictive covenants, coupled with standard debt provisions, help the lender to monitor the
borrower’s activities to ensure efficient use of funds.
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) A sinking-fund requirement requires a corporate to make 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 most cases, the longer the maturity of a bond, the higher is the cost of a bond to the issuer.
13) The lower a bond’s default risk, the higher is the interest rate.
14) 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
15) 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
16) 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
17) A ________ is a restrictive provision in a bond indenture, providing for the systematic retirement of
the bonds prior to their maturity.
A) redemption clause
B) sinking-fund requirement
C) conversion feature
D) subordination clause
18) Bond indentures include restrictive covenants.These provisions protect the bondholders against
________.
A) increase in inflation rate
B) increase in borrower’s risk
C) decrease in liquidity risk
D) maturity risk
19) Which of the following is a restrictive covenant?
A) to maintain satisfactory accounting records
B) to pay the taxes due
C) to supply audited financial statements
D) to impose fixed asset restrictions