Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 7 The Valuation and Characteristics of Bonds
7.1 Learning Objective 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.
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.
3) Convertible bonds decrease in value whenever the price of the company’s stock increases.
4) Junk bonds are also called high-yield bonds.
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.
6) Bonds issued in a country different from the one in which the currency of the bond is
denominated are called Eurobonds.
7) Convertible bonds are debt securities that can be converted into a firm’s stock at a prespecified
price.
8) A mortgage bond is secured by a lien on real property.
9) Shafer Corporation issued callable bonds. The bonds are most likely to be called if
A) interest rates decrease.
B) interest rates increase.
C) Shafer Corporation needs additional financing.
D) Shafer Corporation’s stock price increases dramatically.
10) 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.
11) 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.
12) 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
13) 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.
14) 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
15) 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
16) 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
7.2 Learning Objective 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.
2) A bond with a par value of $1,000 is listed in the Wall Street Journal at a price of 100.50. This
bond is selling for $1,005.
3) Restrictive provisions in bond indenture agreements are designed to protect bondholders and
lessen the agency problems between bondholders and stockholders.
4) 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.
5) Other things held equal, a bond with a call provision is worth more to investors than a bond
without a call provision.
6) Bonds generally have a maturity date while preferred stocks do not.
7) Bond prices are inversely related to market interest rates.
8) If the demand for a new bond issue increases, it is likely that the coupon rate will be adjusted
upward by the issuing company.
9) If a bond’s rating declines, the interest rate demanded by investors, called the required return,
also decreases.
10) A bond is a long-term promissory note issued by the firm.
11) In the case of insolvency, the claims of debt are honored prior to those of common stock and
after those of preferred stock.
12) Debentures are expected to have a lower yield than secured bonds because the debentures are
more risky and therefore less desirable.
13) The Wall Street Journal bond quotes indicate that the net close for a bond with a $1,000 par
value is 100¾. The closing price for that bond was $100.75.
14) Junk bonds typically have an interest rate of between 3 and 5 percent more than AAA-rated
long-term debt.
15) A common protective provision in a bond indenture is the limitation of dividends on the
issuing firm’s common stock.
16) A firm’s bond rating would be favorably affected if they have a low use of financial leverage
(debt).
17) The value of a bond is inversely related to changes in the investor’s present required rate of
return.
18) 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.
19) Liquidation value is of primary importance to investors because it represents the true amount
of cash that an investor is likely to receive.
20) If a bond has a market value that is higher than its par value, then the required return on the
bond must be less than the bond’s coupon rate.
21) 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.
22) 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.
23) A corporate bond has a coupon rate of 12%, 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
24) 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.
25) Market efficiency implies which of the following?
A) book value = intrinsic value
B) market value = intrinsic value
C) book value = market value
D) liquidation value = book value
26) When the intrinsic value of an asset exceeds the market value
A) the asset is undervalued to the investor.
B) the asset is overvalued to the investor.
C) market value and intrinsic value are always the same; therefore, this could not happen.
D) liquidation value must be higher than book value.
27) 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 specific assets other than real estate.
D) Subordinated debentures are riskier than unsubordinated debentures.
28) The present value of the expected future cash flows of an asset represents the asset’s
A) liquidation value.
B) book value.
C) intrinsic value.
D) par value.
29) 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.
30) 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.
31) 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
32) A corporate bond is currently selling for $850. The bond matures in 20 years, has a face
value of $1,000, and a yield to maturity of 10.55%. The bond’s coupon rate is
A) 10%.
B) 11%.
C) 12%.
D) 13%.
33) PDQ bonds have a par value of $1,000. The bonds pay $40 in interest every six months and
will mature in 10 years.
a. Calculate the price if the yield to maturity on the bonds is 7, 8, and 9 percent, respectively.
b. Explain the impact on price if the required rate of return decreases.
c. Compute the coupon rate on the bonds. How does the relationship between the coupon rate
and the yield to maturity determine how a bond’s price will compare to it par value?
10
34) 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
7.3 Learning Objective 3
1) Unlike market value, the intrinsic value of an asset is estimated independently of risk.
2) The par value of a corporate bond indicates the payment that the issuer promises to make to
the bondholder at maturity.
3) The sum of the present values of an investment’s expected future cash flows is known as the
investment’s intrinsic value.
4) In an efficient market, the market value and intrinsic value of a security should be equal.
5) 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.
6) As market rates of interest rise, investors move their funds into bonds, thus increasing their
price and lowering their yield.
7) An individual investor considers investing in an XYZ Corp. bond and decides not to purchase
the bond. Which of the following statements is most correct?
A) The intrinsic value of the bond for the investor is less than the market value of the bond.
B) The liquidation value of the bond is greater than the market value of the bond.
C) The intrinsic value of the bond for the investor is less than the par value of the bond.
D) The intrinsic value of the bond for the investor is greater than the book value of the bond.
8) SWH Corporation issued bonds on January 1, 2004. The bonds had a coupon rate of 5.5%,
with interest paid semiannually. The face value of the bonds is $1,000 and the bonds mature on
January 1, 2019. What is the intrinsic value of an SWH Corporation bond on January 1, 2010 to
an investor with a required return of 7%?
A) $901.08
B) $902.27
C) $1,000.00
D) $1,104.28
9) John owns a corporate bond with a coupon rate of 8% that matures in 10 years. Bill owns a
corporate bond with a coupon rate of 12% that matures in 25 years. If interest rates go down,
then
A) the value of John’s bond will decrease and the value of Bill’s bond will increase.
B) the value of both bonds will increase.
C) the value of Bill’s bond will decrease more than the value of John’s bond due to the longer
time to maturity.
D) the value of both bonds will remain the same because they were both purchased in an earlier
time period before the interest rate changed.
10) In an efficient securities market the market value of a security is equal to:
A) its liquidation value.
B) its book value.
C) its intrinsic value.
D) par value.
11) If markets were entirely efficient (perfect), which of the following would we conclude?
A) There would be no inflation.
B) Book value would be the same as market value.
C) No firms would ever default on their bonds.
D) Market value and intrinsic value would be the same.
12) Finance theory suggests that the current market value of a bond is based upon which of the
following?
A) The future value of interest paid on a bond.
B) The sum total of principal and interest paid on a bond.
C) The sum of the present value of the bond’s interest payments and the present value of the
principal.
D) The present value of a bond’s par value plus the future value of the bond’s present value.
13) Assume that Brady Corp. has an issue of 18-year $1,000 par value bonds that pay 7%
interest, annually. Further assume that today’s required rate of return on these bonds is 5%. How
much would these bonds sell for today? Round off to the nearest $1.
A) $1,233.79
B) $1,201.32
C) $1,134.88
D) $1,032.56
7.4 Learning Objective 4
1) In an efficient market, two investors may agree on the amount and timing of a bond’s expected
cash flows and also on the bond’s risk level, as measured by its debt rating, and still determine
two different values for the bond.
2) Which of the following affect an asset’s value to an investor?
I. Amount of an asset’s expected cash flow
II. The riskiness of the cash flows
III. Timing of an asset’s cash flows
IV. Investor’s required rate of return
A) I, II, III
B) I, III, IV
C) I, II, IV
D) I, II, III, IV
3) Which type of value is shown on the firm’s balance sheet?
A) book value
B) liquidation value
C) market value
D) intrinsic value
7.5 Learning Objective 5
1) What is the value of a bond that has a par value of $1,000, a coupon of $120 (annually), and
matures in 10 years? Assume a required rate of return of 7.8%.
A) $1,198.45
B) $1,200.43
C) $1,284.38
D) $1,349.76
2) What is the value of a bond that matures in 17 years, makes an annual coupon payment of
$50, and has a par value of $1,000? Assume a required rate of return of 6%.
A) $822.90
B) $856.29
C) $895.23
D) $904.87
3) What is the value of a bond that matures in 5 years, has an annual coupon payment of $110,
and a par value of $2,000? Assume a required rate of return of 7%.
A) $938.50
B) $1,876.99
C) $1,890.07
D) $1,750.00
4) As interest rates, and consequently investors’ required rates of return, change over time the
________ of outstanding bonds will change as a result.
A) maturity date
B) coupon interest payment
C) par value
D) price
5) Swanson, Inc. bonds have a 10% coupon rate with semi-annual coupon payments. They have
12 and 1/2 years to maturity and a par value of $1,000. Compute the value of Swanson’s bonds if
investors’ required rate of return is 8%.
A) $1,156.22
B) $1,239.33
C) $1,137.10
D) $1,084.44
6) Homer’s Trucking Company bonds have a 11% coupon rate. Interest is paid semi-annually.
The bonds have a par value of $1,000 and will mature 8 years from now. Compute the value of
Homer’s Trucking Company bonds if investors’ required rate of return is 9.5%.
A) $1,197.27
B) $1,133.05
C) $1,098.99
D) $1,082.75
7) Podunk Communications bonds mature in 6 1/2 years with a par value of $1,000. They pay a
coupon rate of 9% with semi-annual payments. If the required rate of return on these bonds is
11% what is the bond’s value?
A) $1,026.73
B) $973.76
C) $1,022.74
D) $908.83
8) In the present value bond valuation model, risk is generally incorporated into the
A) maturity amount.
B) timing of cash flows (assuming more risky cash flows are received early).
C) discount rate or required return.
D) cash flows (making some smaller if they are more risky).