Finance Chapter 6 Therefore it has the highest interest rate risk

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Chapter 6: Bond Valuation and Interest Rates

Multiple Choice Questions

1. Section: 6.1 The Basic Structure of Bonds

Learning Objective: 6.1

2. Section: 6.1 The Basic Structure of Bonds

Learning Objective: 6.1

3. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Level of difficulty: Intermediate

4. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Intermediate

5. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

6. Section: 6.3 Bond Yields

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Learning Objective: 6.3

Difficulty: Intermediate

7. Section: 6.4 Interest Rate Determinants

Learning Objective: 6.4

Difficulty: Intermediate

8. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Level of difficulty: Intermediate

9. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Intermediate

10. Section: Appendix 6A: Interest Rate Parity

Learning Objective: 6.6

Difficulty: Intermediate

Practice Problems

Basic

11. Section: 6.1 The Basic Structure of Bonds

Learning Objective: 6.1

Difficulty: Basic

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Solution: Positive covenants require firms to undertake some actions, such as make interest

12. Section: 6.2 Bond Valuation

Learning Objective: 6.2

13. Section: 6.2 Bond Valuation

Learning Objective: 6.2

14. Section: 6.2 Bond Valuation

Learning Objective: 6.2

15. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Basic

16. Section: 6.2 Bond Valuation

Learning Objective: 6.2

17. Section: 6.4 Interest Rate Determinants

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Learning Objective: 6.4

Difficulty: Basic

Solution:

18. Section: 6.4 Interest Rate Determinants

Learning Objective: 6.4

Difficulty: Basic

Solution:

The Fisher relationship uses expected inflation figures, not the actual rate of inflation

19. Section: 6.4 Interest Rate Determinants

Learning Objective: 6.4

Level of difficulty: Basic

Solution:

a. We can assume that T-bills (short-term, federal government bonds) have the highest possible

20. Section: 6.4 Interest Rate Determinants

Learning Objective: 6.4

Level of difficulty: Basic

Solution:

21. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Basic

Solution:

22. Section: 6.4 Interest Rate Determinants

Learning Objective: 6.4

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Difficulty: Basic

Solution:

Intermediate

23. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Intermediate

Solution:

Using a financial calculator:

24. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Intermediate

Solution:

a. by financial calculator:

25. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Intermediate

Solution:

26. Section: 6.2 Bond Valuation

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Learning Objective: 6.2

Difficulty: Intermediate

Solution:

27. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Intermediate

Solution

a. The quoted price can be interpreted as a percentage of face value. Therefore, you would pay

28. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Intermediate

29. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Intermediate

Solution:

When the bond was trading at $102.50, the interest rate was lower than the coupon rate. When

30. Section: 6.3 Bond Yields

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

Using a financial calculator:

31. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

32. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

33. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

34. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

Using a financial calculator:

35. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Intermediate

Solution:

Using a financial calculator:

36. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Intermediate

Solution:

37. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Intermediate

Solution:

38. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Intermediate

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Solution:

Find the price of the U.S. T-Bill (remembering to use the correct day-count convention and the

39.

Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Intermediate

Solution:

40. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

41. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

We can calculate yield to maturity using the formula below, where r1, r2, … rn are the spot rates

42. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Intermediate

Solution:

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

43. Section: 6.5 Other Types of Bonds/Debt Instruments

Learning Objective: 6.5

Difficulty: Intermediate

Solution:

First, since the coupon is higher than the market rate of interest, it implies that the bond is trading

44. Section: Appendix 6A: Interest Rate Parity

Learning Objective: 6.6

Difficulty: Intermediate

Solution:

Investing funds in the Canadian T-Bill would give $1,000×1.0450 = $1,045 at the end of one

Challenging

45. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Challenging

Solution:

With a coupon rate equal to the market yield, the price of the bond is $1,000.

46. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Challenging

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Solution:

Using a financial calculator:

47. Section: 6.2 Bond Valuation

Learning Objective: 6.2

Difficulty: Challenging

Solution:

Using a financial calculator:

48. Section: 6.3 Bond Yields

Learning Objective: 6.3

Difficulty: Challenging

Solution:

If the YTM were 10%, the bond’s price would be exactly $1,000. We know the price is higher

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

49. Section: 6.4 Interest Rate Determinants

Learning Objective: 6.4

Difficulty: Challenging

Solution:

50. Section: 6.2 Bond Valuation, 6.3 Bond Yields, and 6.5 Other Types of Bonds/Debt

Instruments

Learning Objective: 6.2; 6.3; 6.5

Difficulty: Challenging

Solution:

a. We do not have a yield to maturity figure with which to discount all the cash flows (coupons

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

51. Section: Appendix 6A: Interest Rate Parity

Learning Objective: 6.6

Difficulty: Challenging

Solution:

According to IRP,

1st: Borrow 677.14 Euros at 6%, which is the equivalent of $1,000 at the spot rate ($1.4768/Euro)

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

52. Section: Appendix 6B: The Yield for Callable Bonds

Learning Objective: 6.7

Difficulty: Challenging

Solution:

We can find the price of the bond using either the YTM or the YTC (but take care to use the

53. Section: Appendix 6B: The Yield for Callable Bonds

Learning Objective: 6.7

Difficulty: Challenging

Solution:

Using a financial calculator:

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

Answers to Concept Review Questions

6.1 The Basic Structure of Bonds

Concept Review Questions

1. In what ways are bonds different from mortgages?

The structure of the payments differs from that of the loan or mortgage discussed in Chapter 5,

2. How is a traditional bond structured?

3. What is a bond indenture?

4. What is the difference between a positive and a negative covenant provision?

Negative covenants prohibit certain actions, for example, a company may be restricted from

5. How do callable bonds differ from retractable and extendable bonds?

Callable bonds give the issuer the option to “call,” or repurchase, outstanding bonds at

6. How do sinking funds work?

There are two ways in which this is done. In the first way the firm repurchases a certain amount

6.2 Bond Valuation

Concept Review Questions

1. What time-value-of-money formula do we need to value a bond?

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

2. When market interest rates are above the coupon rate on a bond, is it a premium or discount

bond?

It is a discount bond. This is because the coupon rate is less than the market interest (discount)

3. If market interest rates go up, what happens to bond prices?

4. Which types of bonds have more interest rate risk: short-term or long-term bonds?

5. What is the day count convention in Canada and the United States?

6.3 Bond Yields

Concept Review Questions

1. Why is there no simple analytical formula for the yield to maturity?

2. When bonds sell above their par value, is the yield to maturity greater or less than the coupon

rate?

6.4 Interest Rate Determinants

Concept Review Questions

1. How does the expected rate of inflation affect nominal interest rates?

2. Why do interest rates differ between Canada and the United States?

Interest rates are heavily influenced by inflation and other domestic macroeconomic variables,

3. Why do interest rates on different-maturity Canada bonds differ?

4. What is a corporate spread?

Corporate spread is the required rate of return of a corporate bond minus risk free rate and

6.5 Other Types of Bonds/Debt Instruments

Concept Review Questions

1. How does the formula for determining the price of a T-bill resemble the formula for

determining the price of a zero coupon bond? Why is this so?

2. How do U.S. bank discount yields differ from bond equivalent yields?

3. How do floaters and real return bonds provide protection against inflation?

Floating rate bonds (floaters) have “adjustable” coupons that are usually tied to some variable

Appendix 6B The Yield for Callable Bonds

Concept Review Questions

1. Is the yield to call always greater than the yield to maturity?

Generally speaking, the yield to call will be greater than the yield to maturity when a callable