bonds and their valuation exercise

8/12/2019 BONDS AND THEIR VALUATION EXERCISE

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(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/Fstatements are used in the MC questions. See the preface for information on the AACS letterindicators !F, M, etc." on the sub#ect lines.

Multiple Choice: True/alse

(9-2) Coupon rate F G Answer: a EASY

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. Trueb. False

(9-2) Call provision F G Answer: b EASY

. ! call pro"ision gi"es 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

(9-2) Sinking fun F G Answer: a EASY

#. $inking funds are pro"isions included in bond indentures that require

companies to retire bonds on a scheduled basis prior to their final

maturity. %any 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 &' selecting the bonds to be called by a

lottery administered by the trustee, in which case the price paid is the

bond(s face "alue.

a. True

b. False

(9-2) !ero "oupon bon F G Answer: b EASY

). ! *ero coupon bond is a bond that pays no interest and is offered &and

initially sells' at par. These bonds pro"ide compensation to in"estorsin the form of capital appreciation.

a. True

b. False

Chapter 9: Bonds True/False Page 227

2013 Cengage Learning. ll !ights !eser"ed. #a$ not %e &opied' s&anned' or dupli&ated' in (hole or in part' e)&ept *or use as per+itted ina li&ense distri%uted (ith a &ertain produ&t or ser"i&e or other(ise on a pass(ord,prote&ted (e%site *or &lassroo+ use.

CH!"TE# $%&'D !'D THE# *!L+!T&'


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(9-2) Floating-rate ebt F G Answer: a EASY

+. The desire for floatingrate bonds, and consequently their increased

usage, arose out of the e-perience of the early 1/0s, when inflation

pushed interest rates up to "ery high le"els and thus caused sharp

declines in the prices of outstanding bonds.

a. Trueb. False

(9-#) $is"ounte "as% flows F G Answer: a EASY

. The market "alue 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

(9-&) 'on pri"es an int rates F G Answer: a EASY

2. The price sensiti"ity of a bond to a gi"en change in interest rates is

generally greater the longer the bond(s remaining maturity.

a. True

b. False

(9-) *ri"e risk F G Answer: b EASY

/. ! bond that had a 0year original maturity with 1 year left to maturity

has more price risk than a 10year original maturity bond with 1 year

left to maturity. &!ssume that the bonds ha"e equal default risk and

equal coupon rates, and they cannot be called.'

a. Trueb. False


. 3ecause shortterm interest rates are much more "olatile than longterm

rates, you would, in the real world, generally be sub4ect to much more

price risk if you purchased a #0day bond than if you bought a #0year

bond.

a. True

b. False

(9-+) 'ons an ebentures F G Answer: a EASY

10. !s a general rule, a company(s debentures ha"e higher required interest

rates than its mortgage bonds because mortgage bonds are backed by

specific assets while debentures are unsecured.

a. True

b. False

Page 22- True/False Chapter 9: Bonds



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(9-+) ,unk bon F G Answer: a EASY

11. 5unk bonds are highrisk, highyield debt instruments. They are often

used to finance le"eraged buyouts and mergers, and to pro"ide financing

to companies of questionable financial strength.

a. True

b. False

(9-+) 'on ratings re. returns F G Answer: a EASY

1. There is an in"erse relationship between bonds( quality ratings and

their required rates of return. Thus, the required return is lowest for

!!!rated bonds, and required returns increase as the ratings get lower.

a. True

b. False

(9-2) /n"o0e bon F G Answer: b 1E$/1

1#. 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 in"estor(s perspecti"e than regular

bonds.

a. True

b. False

(9-2) Sinking fun F G Answer: b 1E$/1

1). 6ou are considering bonds that will be issued tomorrow. 3oth are

rated triple 3 &333, the lowest in"estmentgrade rating', both mature in

0 years, both ha"e a 107 coupon, neither can be called e-cept for

sinking fund purposes, and both are offered to you at their 81,000 par

"alues. 9owe"er, 3ond $F has a sinking fund while 3ond :$F does not.

;nder the sinking fund, the company must call and pay off +7 of thebonds at par each year. The yield cur"e at the time is upward sloping.

The bond(s prices, being equal, are probably not in equilibrium, as 3ond

$F, which has the sinking fund, would generally be e-pected to ha"e a

higher yield than 3ond :$F.

a. True

b. False

(9-2) Floating-rate ebt F G Answer: b 1E$/1

1+. Floatingrate debt is ad"antageous to in"estors because the interest

rate mo"es up if market rates rise. $ince floatingrate debt shifts

price risk to companies, it offers no ad"antages to corporate issuers.

a. True

b. False

(9-#) 'on pre0iu0s an is"ounts F G Answer: a 1E$/1

1. ! bond has a 81,000 par "alue, makes annual interest payments of 8100,

has + years to maturity, cannot be called, and is not e-pected to

default. The bond should sell at a premium if market interest rates are

below 107 and at a discount if interest rates are greater than 107.

Chapter 9: Bonds True/False Page 229



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a. True

b. False

Page 230 True/False Chapter 9: Bonds



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(9-#) 'on value--annual pa30ent F G Answer: a 1E$/1

12. 6ou ha"e funds that you want to in"est in bonds, and you 4ust noticed in

the financial pages of the local newspaper that you can buy a 81,000 par

"alue bond for 8/00. The coupon rate is 107 &with annual payments', and

there are 10 years before the bond will mature and pay off its 81,000

par "alue. 6ou should buy the bond if your required return on bonds

with this risk is 17.

a. True

b. False

(9-&) 'on pri"es an returns F G Answer: a 1E$/1

1/. If the required rate of return on a bond &rd' is greater than its coupon

interest rate and will remain abo"e that rate, then the market "alue of

the bond will always be below its par "alue until the bond matures, at

which time its market "alue will equal its par "alue. &!ccrued interest

between interest payment dates should not be considered when answering

this question.'

a. Trueb. False

(9-&) *ri"es an interest rates F G Answer: a 1E$/1

1. The prices of highcoupon bonds tend to be less sensiti"e to a gi"en

change in interest rates than lowcoupon bonds, other things held

constant.

a. True

b. False

&9-+) 4estri"tive "ovenants F G Answer: a 1E$/1

0

.


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Multiple Choice: Conceptual

Most of these questions can be answered b$ thin%in& about relationships and reasonin& outwhich answer is correct, but some require students to do a few calculations. 'ven if lo&ical

answers can be determined, it ma$ be useful to confirm them b$ wor%in& out some numbers.Sometimes data are provided in the question, but sometimes students must ma%e up their owne(amples to ta%e the numerical approach.

Most students will have to thin% carefull$ to answer the M')*+M and A-) questions,and that will ta%e some time. Therefore, the more time the$ have to do the test or qui, the bettertheir scores should be.

Some of the questions are focused on a particular section, but others have statementsthat are covered in various sections. *n the latter case, we indicate Comprehensive0 ratherthan &ive a section number.

Finall$, note that we provide answers onl$ to selected questions. 1e see no need toanswer relativel$ eas$, obvious questions, so we limit answers to questions where students mi&ht

have trouble understandin& wh$ their answer is wron&.(9-&) /nterest rates C G Answer: a EASY

#. >hich of the following statements is ?=


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(9-+) 'on ratings C G Answer: " EASY

+. !ssume that interest rates on 0year Treasury and corporate bonds with

different ratings, all of which are noncallable, are as followsC

Tbond D 2.27 ! D .)7

!!! D /.27 333 D 10.1/7

The differences in rates among these issues were most probably caused

primarily byC

a.


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(9-2) Convertible7 "allable bons C G Answer: b 1E$/1

/. !mram Inc. can issue a 0year bond with a 7 annual coupon at par.

This bond is not con"ertible, not callable, and has no sinking fund.

!lternati"ely, !mram could issue a 0year bond that is con"ertible into

common equity, may be called, and has a sinking fund. >hich of the

following most accurately describes the coupon rate that !mram would

ha"e to pay on the second bond, the con"ertible, callable bond with thesinking fund, to ha"e it sell initially at parA

a. The coupon rate should be e-actly equal to 7.

b. The coupon rate could be less than, equal to, or greater than 7,

depending on the specific terms set, but in the real world the

con"ertible feature would probably cause the coupon rate to be less

than 7.

c. The rate should be slightly greater than 7.

d. The rate should be o"er 27.

e. The rate should be o"er /7.

(9-5) 'on 3iels C G Answer: 1E$/1

. Tucker ?orporation is planning to issue new 0year bonds. The currentplan is to make the bonds noncallable, but this may be changed. If the

bonds are made callable after + years at a +7 call premium, how would

this affect their required rate of returnA

a. 3ecause of the call premium, the required rate of return would

decline.

b. There is no reason to e-pect 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.

(9-5) 'on 3iels C G Answer: a 1E$/1

#0. ! 10year corporate bond has an annual coupon of 7. The bond is

currently selling at par &81,000'. >hich of the following statements is

?=


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d. If a bondBs yield to maturity e-ceeds its coupon rate, the bond will

sell at a premium o"er par.

e. !ll else equal, if a bondBs yield to maturity increases, its current

yield will fall.

(9-5) 'on 3iels C G Answer: " 1E$/1

#. ! 1+year bond with a face "alue of 81,000 currently sells for 8/+0.>hich of the following statements is ?=


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(9-&) /nt rates an bon pri"es C G Answer: b 1E$/1

#+. ! 10year bond pays an annual coupon, its 6T% is /7, and it currently

trades at a premium. >hich of the following statements is ?=hich of the following statements is ?=hich of the following

statements is ?=


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e. The prices of both bonds will increase o"er time, but the price of

3ond ! will increase at a faster rate.

Chapter 9: Bonds Con&eptual #/C Page 237



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(9-) *ri"e risk C G Answer: e 1E$/1

#. >hich of the following bonds would ha"e the greatest percentage increase

in "alue if all interest rates in the economy fall by 17A

a. 10year, *ero coupon bond.

b. 0year, 107 coupon bond.

c. 0year, +7 coupon bond.d. 1year, 107 coupon bond.

e. 0year, *ero coupon bond.

(9-) *ri"e risk C G Answer: 1E$/1

)0. !ssume that all interest rates in the economy decline from 107 to 7.

>hich of the following bonds would ha"e the largest percentage increase

in priceA

a. !n /year bond with a 7 coupon.

b. ! 1year bond with a 1+7 coupon.

c. ! #year bond with a 107 coupon.

d. ! 10year *ero coupon bond.

e. ! 10year bond with a 107 coupon.

(9-) *ri"e risk C G Answer: b 1E$/1

)1. >hich of the following bonds has the greatest price riskA

a. ! 10year 8100 annuity.

b. ! 10year, 81,000 face "alue, *ero coupon bond.

c. ! 10year, 81,000 face "alue, 107 coupon bond with annual interest

payments.

d. !ll 10year bonds ha"e the same price risk since they ha"e the same

maturity.

e. ! 10year, 81,000 face "alue, 107 coupon bond with semiannual

interest payments.

(9-) *ri"e risk C G Answer: e 1E$/1

). If its yield to maturity declined by 17, which of the following bonds

would ha"e the largest percentage increase in "alueA

a. ! 1year *ero coupon bond.

b. ! 1year bond with an /7 coupon.

c. ! 10year bond with an /7 coupon.

d. ! 10year bond with a 17 coupon.

e. ! 10year *ero coupon bond.

(9-) *ri"e vs reinvest risk C G Answer: e 1E$/1

)#. >hich of the following statements is ?=


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d. !ll else equal, shortterm bonds ha"e less rein"estment risk than

longterm bonds.

e. !ll else equal, longterm bonds ha"e less rein"estment risk than

shortterm bonds.

Chapter 9: Bonds Con&eptual #/C Page 239



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(9-) *ri"e vs reinvest risk C G Answer: 1E$/1

)). >hich of the following statements is ?=hich of the following statements is ?=


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d. If a bondBs yield to maturity e-ceeds its annual coupon, then the

bond will trade at a premium.

e. If a coupon bond is selling at a premium, its current yield equals

its yield to maturity.

(Co0p) 'on "on"epts C G Answer: 1E$/1

)/

. ! 10year bond with a 7 annual coupon has a yield to maturity of /7.>hich of the following statements is ?=hich of the following statements is ?=


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d. If a bond is selling at a premium, its current yield will be less

than its capital gains yield.

e. !ll else equal, bonds with larger coupons ha"e less price risk than

bonds with smaller coupons.

Page 22 Con&eptual #/C Chapter 9: Bonds



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(Co0p) 'on "on"epts C G Answer: b 1E$/1

+. >hich of the following statements is ?=


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(Co0p) 'on "on"epts C G Answer: a 1E$/1

++. 3ond H has an /7 annual coupon, 3ond 6 has a 107 annual coupon, and 3ond

has a 17 annual coupon. @ach of the bonds is noncallable, has a

maturity of 10 years, and has a yield to maturity of 107. >hich of the

following statements is ?=


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(Co0p) 'on 3iels C G Answer: 1E$/1

+/. >hich of the following statements is ?=hich of the following statements is ?=


20/42

(Co0p) 'on rates an pri"es C G Answer: e 1E$/1

1. 3ond ! has a 7 annual coupon, while 3ond 3 has a 27 annual coupon.

3oth bonds ha"e the same maturity, a face "alue of 81,000, an /7 yield

to maturity, and are noncallable. >hich of the following statements is

?=hich of the following statements is ?=


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(Co0p) 1is"ellaneous "on"epts C G Answer: 1E$/1

). >hich of the following statements is ?=hich of the following statements is ?=hich of the following statements is ?=


22/42

(Co0p) Calling a bon C G Answer: " 1E$/16A4$

2. >hich of the following statements is ?=


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(9-) *ri"e an reinvest risk C G Answer: b 6A4$

20. >hich of the following statements is ?=


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(Co0p) Costs of t3pes of ebt C G Answer: " 6A4$

2. $uppose a new company decides to raise a total of 800 million, with

8100 million as common equity and 8100 million as longterm debt. The

debt can be mortgage bonds or debentures, but by an ironclad pro"ision

in its charter, the company can ne"er raise any additional debt beyond

the original 8100 million. Ji"en these conditions, which of the

following statements is ?=


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(Co0p) 'on "on"epts C G Answer: e 6A4$

2). !ssuming all else is constant, which of the following statements is

?=


26/42

d. ./17

e. 2.127

Page 22 #/C Pro%le+s Chapter 9: Bonds



27/42

(9-5) Yiel to 0aturit3 C G Answer: b EASY

2/. Eyl Inc.(s bonds currently sell for 81,0)0 and ha"e a par "alue of

81,000. They pay a 8+ annual coupon and ha"e a 1+year maturity, but

they can be called in + years at 81,100. >hat is their yield to

maturity &6T%'A

a. +.2/7b. .07

c. .#7

d. .217

e. 2.0+7

(9-5) Yiel to 0aturit3 C G Answer: b EASY

2. hat is the yield to maturity on these bondsA

a. +.+7

b. +./7

c. .117d. .)17

e. .2#7

(9-5) Yiel to "all C G Answer: EASY

/0. $adik Inc.(s bonds currently sell for 81,1/0 and ha"e a par "alue of

81,000. They pay a 810+ annual coupon and ha"e a 1+year maturity, but

they can be called in + years at 81,100. >hat is their yield to call

&6T?'A

a. .#7

b. ./7

c. 2.#+7

d. 2.2)7e. /.17

(9-5) Current 3iel C G Answer: a EASY

/1. %alko @nterprisesB bonds currently sell for 81,0+0. They ha"e a year

maturity, an annual coupon of 82+, and a par "alue of 81,000. >hat is

their current yieldA

a. 2.1)7

b. 2.+07

c. 2.//7

d. /.27

e. /./7

(9-) 'on valuation: se0iannual C G Answer: a EASY

/. !ssume that you are considering the purchase of a 0year, noncallable

bond with an annual coupon rate of .+7. The bond has a face "alue of

81,000, and it makes semiannual interest payments. If you require an

/.)7 nominal yield to maturity on this in"estment, what is the ma-imum

price you should be willing to pay for the bondA

a. 81,10+.

Chapter 9: Bonds #/C Pro%le+s Page 23



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b. 81,1##.#)

c. 81,11.2

d. 81,10.21

e. 81,0.)/

(9-#) 'on valuation: annual C G Answer: e 1E$/1

/#. Jrossnickle ?orporation issued 0year, noncallable, 2.+7 annual couponbonds at their par "alue of 81,000 one year ago. Today, the market

interest rate on these bonds is +.+7. >hat is the current price of the

bonds, gi"en that they now ha"e 1 years to maturityA

a. 81,11#.)/

b. 81,1).0#

c. 81,121.#

d. 81,01.#+

e. 81,#.1+

(9-5) Y81 an Y8C C G Answer: a 1E$/1

/). %c?ue Inc.(s bonds currently sell for 81,+0. They pay a 80 annual

coupon, ha"e a +year maturity, and a 81,000 par "alue, but they can becalled in + years at 81,0+0. !ssume that no costs other than the call

premium would be incurred to call and refund the bonds, and also assume

that the yield cur"e is hori*ontal, with rates e-pected to remain at

current le"els on into the future. >hat is the difference between this

bond(s 6T% and its 6T?A &$ubtract the 6T? from the 6T% it is possible

to get a negati"e answer.'

a. .7

b. .//7

c. #.127

d. #.)/7

e. #./#7

(9-5) Y81 an Y8C C G Answer: e 1E$/1

/+. Taussig ?orp.(s bonds currently sell for 81,1+0. They ha"e a .#+7

annual coupon rate and a 0year maturity, but they can be called in +

years at 81,02.+0. !ssume that no costs other than the call premium

would be incurred to call and refund the bonds, and also assume that the

yield cur"e is hori*ontal, with rates e-pected to remain at current

le"els on into the future. ;nder these conditions, what rate of return

should an in"estor e-pect to earn if he or she purchases these bondsA

a. #.)7

b. #.07

c. #.27

d. #.7e. ).07

(9-&) Future annual bon value C G Answer: " 1E$/1

/. ! +year, 81,000 par "alue bond has an /.+7 annual payment coupon. The

bond currently sells for 8+. If the yield to maturity remains at its

current rate, what will the price be + years from nowA

a. 8//).1




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b. 80./

c. 8#0.11

d. 8+#.#

e. 822.0




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(9-) 'on valuation: se0iannual C G Answer: " 1E$/1

/2. %oerdyk ?orporation(s bonds ha"e a 1+year maturity, a 2.+7 semiannual

coupon, and a par "alue of 81,000. The going interest rate &rd' is

.07, based on semiannual compounding. >hat is the bondBs priceA

a. 81,0)2.1

b. 81,02).0+c. 81,101.+/

d. 81,1.1

e. 81,1+2.#+

(9-) 1arket value: se0iannual C G Answer: b 1E$/1

//. In order to accurately assess the capital structure of a firm, it is

necessary to con"ert its balance sheet figures from historical book

"alues to market "alues. K5% ?orporation(s balance sheet &book "alues'

as of today is as followsC

Gongterm debt &bonds, at par' 8#,+00,000

Lreferred stock ,000,000

?ommon stock &810 par' 10,000,000hat is the current

market "alue of the firm(s debtA

a. 812,)#,#2

b. 812,//#,#0

c. 81/,##0,)0#

d. 8 2,20,000

e. 8 2,//,+0

(9-) Se0iannual Y81 an Y8C C G Answer: b 6A4$

/. Keenan Industries has a bond outstanding with 1+ years to maturity, an

/.+7 nominal coupon, semiannual payments, and a 81,000 par "alue. The

bond has a .+07 nominal yield to maturity, but it can be called in

years at a price of 81,10. >hat is the bondBs nominal yield to callA

a. .07

b. .+#7

c. ./+7

d. 2.07

e. 2.++7

(9-) Se0iannual bon "oupon C G Answer: e 6A4$

0. =(3rien Gtd.(s outstanding bonds ha"e a 81,000 par "alue, and they

mature in + years. Their nominal yield to maturity is .+7, they pay

interest semiannually, and they sell at a price of 82+. >hat is the

bond(s nominal coupon interest rateA

a. 2.#7

b. 2.217




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c. /.17

d. /.+)7

e. /.7




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(9-) 'ons: se0iannual EFF; C G Answer: " 6A4$

1. Kebt ?orporation(s ?lass $emi bonds ha"e a 1year maturity and an /.2+7

coupon paid semiannually &).#2+7 each months', and those bonds sell at

their 81,000 par "alue. The firm(s ?lass !nn bonds ha"e the same risk,

maturity, nominal interest rate, and par "alue, but these bonds pay

interest annually. :either bond is callable. !t what price should the

annual payment bond sellA

a. 8 #2.+

b. 8 1.0

c. 8 /.+

d. 81,010.1

e. 81,0#.1/

(9-) 'ons: se0iannual


33/42

Chapter 9: Bonds ns(ers Page 29


CH!"TE# $!'-E# !'D &L+T&'


34/42

1 (9-2) Coupon rate F G Answer: a EASY

(9-2) Call provision F G Answer: b EASY

# (9-2) Sinking fun F G Answer: a EASY

) (9-2) !ero "oupon bon F G Answer: b EASY

+ (9-2) Floating-rate ebt F G Answer: a EASY

(9-#) $is"ounte "as% flows F G Answer: a EASY

2 (9-&) 'on pri"es an int rates F G Answer: a EASY

/ (9-) *ri"e risk F G Answer: b EASY


10 (9-+) 'ons an ebentures F G Answer: a EASY

11 (9-+) ,unk bon F G Answer: a EASY

1 (9-+) 'on ratings re. returns F G Answer: a EASY

1# (9-2) /n"o0e bon F G Answer: b 1E$/1

1) (9-2) Sinking fun F G Answer: b 1E$/1

The sinking fund would give Bond SF a lower average maturity, and it would also lower its risk. Therefore,Bond SF should have a lower, not a higher, yield.

1+ (9-2) Floating-rate ebt F G Answer: b 1E$/1

Floating rates can benefit issuers if rates decline, so a company that thinks rates are likely to fall would wantto issue such bonds.

1 (9-#) 'on pre0iu0s an is"ounts F G Answer: a 1E$/1

12 (9-#) 'on value--annual pa30ent F G Answer: a 1E$/1

The bonds expected return (T!" is #$.%#&, which exceeds the #'& reuired return, so buy the bond.

1/ (9-&) 'on pri"es an returns F G Answer: a 1E$/1

1 (9-&) *ri"es an interest rates F G Answer: a 1E$/1

The reason for this is that more of the cash flows of a low)coupon bond comes late in the bond*s life (as thematurity payment", and later cash flows are impacted most heavily by changing market rates.

0 (9-+) 4estri"tive "ovenants F G Answer: a 1E$/1

1 (9-+) 'ons an ebentures F G Answer: a 1E$/1

(9-5) Callable bons F G Answer: b 6A4$

The callable bond will be called if rates fall far enough below the coupon rate, but it will not be calledotherwise. Thus, the call provision can only harm bondholders. Therefore, callable bonds sell at higheryields than noncallable bonds, regardless of the slope of the yield curve.


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# (9-&) /nterest rates C G Answer: a EASY

) (9-) Calling bons C G Answer: " EASY

+ (9-+) 'on ratings C G Answer: " EASY

(9-2) 'on "oupon rate C G Answer: b 1E$/1

2 (9-2) Sinking funs C G Answer: a 1E$/1

/ (9-2) Convertible7 "allable bons C G Answer: b 1E$/1

The second bond*s convertible feature and sinking fund would tend to lower its reuired rate of return, butthe call feature would raise its rate. +iven these opposing forces, the second bond*s reuired coupon ratecould be above or below that of the first bond. owever, the convertible feature generally dominates in thereal world, so convertibles* coupon rates are generally less than comparable non)convertible issues* rates.

(9-5) 'on 3iels C G Answer: 1E$/1

#0 (9-5) 'on 3iels C G Answer: a 1E$/1

#1 (9-5) 'on 3iels C G Answer: " 1E$/1

# (9-5) 'on 3iels C G Answer: " 1E$/1

## (9-5) 'on 3iels C G Answer: 1E$/1

#) (9-&) 'on values over ti0e C G Answer: 1E$/1

-ote that Bond # sells at par, so the reuired return on all these bonds is #&. #*s price will remainconstant/ % will sell initially at a discount and will rise, and #' will sell initially at a premium and willdecline. -ote too that since it has larger cash flows from its higher coupons, Bond #' would be lesssensitive to interest rate changes, i.e., it has less price risk. 0t has more default risk.

#+ (9-&) /nt rates an bon pri"es C G Answer: b 1E$/1

1nswers c, d, and e are clearly wrong, and answer b is clearly correct. 1nswer a is also wrong, but this isnot obvious to most people. 2e can demonstrate that a is incorrect by using the following example.

3ar 4#,T! %.&!aturity #3rice 4#,#3ayment 456.57oupon rate 5.65&7urrent yield %.8$& The current yield is greater than %&.

# (9-&) /nt rates an bon pri"es C G Answer: " 1E$/1

#2 (9-&) /nt rates an bon pri"es C G Answer: b 1E$/1

2e can tell by inspection that c, d, and e are all incorrect. a is also incorrect because the #)year bond willfall more due to its longer maturity and lower coupon. That leaves 1nswer b as the only possibly correctstatement . 9ecogni:e that longer)term bonds, and ones where payments come late (like low coupon bonds"are most sensitive to changes in interest rates. Thus, the #)year, %& coupon bond should be more sensitiveto a decline in rates. ou could also do some calculations to confirm that b is correct.

#/ (9-&) 'on 3iels an pri"es C G Answer: " 1E$/1

# (9-) *ri"e risk C G Answer: e 1E$/1


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)0 (9-) *ri"e risk C G Answer: 1E$/1

)1 (9-) *ri"e risk C G Answer: b 1E$/1

) (9-) *ri"e risk C G Answer: e 1E$/1

)# (9-) *ri"e vs reinvest risk C G Answer: e 1E$/1

)) (9-) *ri"e vs reinvest risk C G Answer: 1E$/1

)+ (Co0p) 8er0 stru"ture C G 6 Answer: e 1E$/1

) (Co0p) 'ons efault risk C G Answer: a 1E$/1

)2 (Co0p) 'on "on"epts C G Answer: a 1E$/1

)/ (Co0p) 'on "on"epts C G Answer: 1E$/1

) (Co0p) 'on "on"epts C G Answer: e 1E$/1

+0 (Co0p) 'on "on"epts C G Answer: b 1E$/1

+1 (Co0p) 'on "on"epts C G Answer: e 1E$/1

+ (Co0p) 'on "on"epts C G Answer: b 1E$/1

+# (Co0p) 'on "on"epts C G Answer: e 1E$/1

+) (Co0p) 'on "on"epts C G Answer: a 1E$/1

++ (Co0p) 'on "on"epts C G Answer: a 1E$/1

+ (Co0p) 'on "on"epts C G Answer: 1E$/1

1 is a high coupon bond because it sells above par, 7 is a low coupon bond, and B yields the going marketrate. 7onsider this when ruling out a, b, c, and e. d is obviously correct.

+2 (Co0p) 'on "on"epts C G Answer: " 1E$/1

+/ (Co0p) 'on 3iels C G Answer: 1E$/1

+ (Co0p) 'on 3iels C G Answer: e 1E$/1

0 (Co0p) 'on 3iels an pri"es C G Answer: 1E$/1

1 (Co0p) 'on rates an pri"es C G Answer: e 1E$/1

(Co0p) Callable bons C G Answer: a 1E$/1

a is correct because, with the current market rate below the coupon bond, both bonds will sell at a premium,but the premium will be larger for the noncallable bond. The same logic explains why d is false.

# (Co0p) 83pes of ebt C G Answer: " 1E$/1

) (Co0p) 1is"ellaneous "on"epts C G Answer: 1E$/1

+ (Co0p) 1is"ellaneous "on"epts C G Answer: " 1E$/1

(Co0p) $efault an bankrupt"3 C G Answer: e 1E$/1


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2 (Co0p) Calling a bon C G Answer: " 1E$/16A4$

1 bond would not be called unless the current rate was below the T!, in which case it would sell at apremium, because only then would it be profitable to refund the bond. The investor would get the funds,then reinvest at the new low market rate. Thus, the investor would end up earning less than the T!, evenafter receiving the call premium.

/ (9-5) Current 3iel an Y81 C G Answer: b 6A4$

1nswer a is incorrect because a premium bond must have a negative capital gains yield. 1nswer c isincorrect because a bond selling at par must have a current yield eual to its T!. 1nswer d is incorrectbecause a bond selling at below par must have a T! ; the coupon rate. 1nswer e is incorrect because adiscount bond*s price must rise over time. That leaves answer b as the only possibly correct answer. -otethat T! < 7urrent yield =>) 7apital gains yield, so 7urrent yield < T! =>) 7apital gains yield. Thecapital gains yield will be positive or negative depending on whether the coupon rate is above or below theT!. That means that the current yield must either eual the T! or be between the T! and the couponrate. b*s correctness is also demonstrated below?

3ar bond 3remium @iscount3ar 4#, 4#, 4#,!aturity # # #7oup rate #& ##& 5&

T! #.& #.& #.&1nn coup 4#. 4##. 45.3rice 4#,. 4#,8#.6A 45$%.AA7ur ield #.& #.$8& 5.A5& ual to or between T! and coupon rate.7ap gain .& ).$8& .6#&

(9-&) /nt rates an bon pri"es C G Answer: a 6A4$

2e can tell by inspection that c, d, and e are all incorrect. That leaves 1nswers a and b as the only possiblycorrect statements. 1lso, recogni:e that longer)term bonds, and also bonds whose payments come late (like lowcoupon bonds" are most sensitive to changes in interest rates. Thus, the #A)year, %& coupon bond would be moresensitive to a decline in rates. Finally, we can do some calculations to confirm that a is the correct answer?

7urrent situation 9ates decline#)year #A)year #)year #A)year

3ar 4#, 4#, 4#, 4#,!aturity # #A # #A

7oup rate #'& %& #'& %&T! #.& #.& 5.& 5.&1nn coup 4#' 4% 4#' 4%3rice 4#,#''.%5 4%6C.%% 4#,#5'.A$ 45#5.$5& +ain 8.'& %.6&

20 (9-) *ri"e an reinvest risk C G Answer: b 6A4$

21 (9-+) 'on inenture C G Answer: a 6A4$

2 (Co0p) Costs of t3pes of ebt C G Answer: " 6A4$


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The higher the percentage of mortgage bonds, the less the collateral backing each bond, so these bonds* riskand thus reuired return would be higher. 1lso, the higher the percentage of mortgage bonds, the less freeassets would be backing the debentures, so their risk and reuired return would also be higher. owever,mortgage bonds are less risky than debentures, so mortgage bond rates are lower than rates on debentures. 2eend up with a situation where the greater the percentage of mortgage bonds, the higher the rate on both typesof bonds, but the average cost to the company could be higher, lower, or constant. -ote that we could draw agraph of the situation, with & mortgage on the hori:ontal axis and rates on the vertical axis, the graph wouldlook like the 2177 graph in the cost of capital chapter.

2# (Co0p) Costs of t3pes of ebt C G Answer: b 6A4$

0n Statement b, note that if only 4A, of #st mortgage bonds were secured by 4# million of property, eachof those bonds would be less risky than if there were 4# million of bonds backed by the 4# million of property.-ote too that the cost of the total 4# million of debt would be an average of the cost of the mortgage bonds andthe debentures, and that average cost could be higher, lower, or the same as if only mortgage bonds or onlydebentures were used.

2) (Co0p) 'on "on"epts C G Answer: e 6A4$

0t is relatively easy to eliminate a, c, and d. 2hen choosing between b and e, think about the graph that showsthe relationship between a bond*s price and the going interest rate. This curve is concave, indicating that atany interest rate, the decline in price from an increase in rates is less than the gain in price from a similar

interest rate decline. 0t would be easy to confirm this statement with an example.

2+ (9-#) 'on valuation: annual C G Answer: a EASY

- %0>9 %.'&3!T 48AFD 4#,3D 45$.6

2 (9-#) 'on valuation: annual C G Answer: EASY

7oupon rate A.C&

3!T 4AC.- #A0>9 C.&FD 4#,3D 4%%#.8

22 (9-5) Yiel to 0aturit3 C G Answer: e EASY

- #A3D 4#,#'3!T 4%AFD 4#,0>9 C.#C&

2/ (9-5) Yiel to 0aturit3 C G Answer: b EASY

- #A3D 4#,63!T 48AFD 4#,0>9 8.5& < T!

2 (9-5) Yiel to 0aturit3 C G Answer: b EASY

7oupon rate C.$A&


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- #'3D < 3rice 4#,#$3!T 4C$.AFD < 3ar 4#,0>9 A.%'& < T!

/0 (9-5) Yiel to "all C G Answer: EASY

- A3D 4#,#%3!T 4#AFD 4#,#0>9 < T7 C.C6&

/1 (9-5) Current 3iel C G Answer: a EASY

3D 4#,A3!T 4CA7urrent yield < C.#6&

/ (9-) 'on valuation: se0iannual C G Answer: a EASY

3ar value 4#,7oupon rate 5.A&3eriods>year 'rs to maturity '

3eriods < rs to maturity E 3eriods>year 69euired rate %.6&3eriodic rate < 9euired rate>' < 0>9 6.'&3!T per period < 7oupon rate>' E 3ar value 46C.A!aturity value < FD 4#,3D 4#,#A.85

/# (9-#) 'on valuation: annual C G Answer: e 1E$/1

3ar value < !aturity value < FD 4#,7oupon rate C.A&ears to maturity < - #59euired rate < 0>9 A.A&(7oupon rate"(3ar value" < 3!T 4CA

3D 4#,'$'.#A

/) (9-5) Y81 an Y8C C G Answer: a 1E$/1

0f held to maturity? 0f called in A years?- < !aturity 'A - < 7all A3rice < 3D 4#,'A 3D 4#,'A3!T 45 3!T 45FD < 3ar 4#, FD < 7all 3rice 4#,A0>9 < T! 8.%%& 0>9 < T7 6.'8&@ifference? T! T7 < '.8'&


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/+ (9-5) Y81 an Y8C C G Answer: e 1E$/1

0f the coupon rate exceeds the T!, then it is likely that the bonds will be called and replaced with new,lower coupon bonds. 0n that case, the T7 will be earned. Gtherwise, one should expect to earn the T!.

0f held to maturity? 0f called?3ar value 4#, 3ar value 4#,

7oupon 8.$A& 7oupon 8.$A&- ' - A3rice < 3D 4#,#A 3D 4#,#A3!T < 3ar E 7oupon 48$.A 3!T 48$.AFD 4#,. FD 4#,8C.A0>9 < T! A.#$& 0>9 < T7 6.'&xpected rate of return < T7 if 7oupon ; T!, 6.'& T7otherwise T!

/ (9-&) Future annual bon value C G Answer: " 1E$/1

First find the T! at this time, then use the T! with the other data to find the bond*s price A years hence.

3ar value 4#,7oupon rate %.A& Dalue in A years?- 'A - '3D 45'A 0>9 5.'%&3!T 4%A 3!T 4%AFD 4#, FD 4#,

0>9 5.'%& 3D 45$.##

/2 (9-) 'on valuation: se0iannual C G Answer: " 1E$/1

3ar value < FD 4#,7oupon rate C.'A&3eriods>year 'rs to maturity #A3eriods < ears E ' < - $+oing annual rate < T! < rd 8.'&3eriodic rate < rd>' < 0>9 $.#&7oupon rate E 3ar>' < 3!T 4$8.'A3D 4#,##.A%

// (9-) 1arket value: se0iannual C G Answer: b 1E$/1

7alculate the price of each bond?7oupon rate C.&3ar value < FD 4#,rs to maturity #3eriods>r '3eriods < ears E ' < - '+oing annual rate < rd< T! ##.&3eriodic rate < rd>' < 0>9 A.A&7oupon rate E 3ar>' < 3!T 4$A.


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3rice of the bonds < 3D 4C8.55

@etermine the number of bonds?Book value on balance sheet 4'$,A,3ar value 4#,-umber of bonds < Book value>3ar value '$,A

7alculate the market value of bonds?

!kt value < 3D E -umber of bonds < 4#C,%%$,$'

/ (9-) Se0iannual Y81 an Y8C C G Answer: b 6A4$

First, use the given data to find the bond*s current price. Then use that price to find the T7.

7oupon rate %.'A&T! 8.A&!aturity #A rs to call 83ar value 4#, 7all price 4#,#'3eriods>year ' @etermine the bond*s T7?@etermine the bond*s price? - #'3!T>period 46#.'A 3D 4#,#88.5- $ 3!T 46#.'A0>9 $.'A& FD 4#,#'.

FD 4#,. 0>9 $.'8&3D < 3rice 4#,#88.5 -om. T7 8.A$&

0 (9-) Se0iannual bon "oupon C G Answer: e 6A4$

First, use the data provided to find the dollar coupon payment per 8 months, then multiply by ' to get the annualcoupon, and then divide by the par value to find the coupon rate. Gne could use the indicated data and solve forthe price. 0t would be 45CA, which confirms the rate.

3ar value < FD 4#,ears to maturity 'A3eriods>year 'ears E periods>year < - AT! 5.'A&

3eriodic rate < T!>' < 0>9 6.8'A&3rice today < 3D 45CA3!T, function of -, 0>9, 3D, and FD < semiannual pymt 466.581nnual coupon payment < semiannual payment E ' < 4%5.5'7oupon rate < 1nnual coupon payment>3ar value < %.55&

1 (9-) 'ons: se0iannual EFF; C G Answer: " 6A4$

These two bonds should provide the same FF&. Therefore, we can find the FF& for the semiannual bond andthen use it as the T! for the annual payment bond. 1t the calculated price, the two bonds will have T!s withthe same FF&. -ote too that the semiannual payment bond must have a higher price than the annual bond


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because then it receives the same cash flow, but faster. Therefore, the annual bond must sell at a price below the4#, par value at which the semiannual bond sells.

Semiannual bond? 1nnual bond?3ar value 4#, 3ar value 4#,7oupon rate3eriod 4%C.Aears to maturity #' rs to maturity #'

3eriods>year ' 3eriods>year #Total periods '6 Total periods #'FF& < (#=-om rate>'"'H # < %.56#& FF& < T! %.56#&3rice 4#,. 3rice 45%8.'A

(9-) 'ons: se0iannual

bonds and their valuation exercise

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