CORPORATE FINANCE ProbSet Chapter 5 (13e) Bond Valuation & Interest Rates BONDS 1.

. A 10-year corporate bond has an annual coupon payment of 9 percent. The bond is currently selling at par ($1,000). Which of the following statements is true about this bond? a. b. c. d. e. The bonds yield to maturity is 9 percent. The bonds current yield is 9 percent. If the bonds yield to maturity remains constant, the bonds price will remain at par. Both answers a and c are correct. All of the answers above are correct.

2. Which of the following statements is most accurate about bond yields and prices? a. Rising inflation makes the actual yield to maturity on a bond greater than the quoted yield to maturity which is based on market prices. b. The yield to maturity for a coupon bond that sells at its par value consists entirely of an interest yield; it has a zero expected capital gains yield. c. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss. d. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm enters bankruptcy. e. All of the statements above are false. 3. If the yield to maturity decreased 1 percentage point, which of the following bonds would have the largest percentage increase in value? a. b. c. d. e. A 1-year bond with an 8 percent coupon. A 1-year zero-coupon bond. A 10-year zero-coupon bond. A 10-year bond with an 8 percent coupon. A 10-year bond with a 12 percent coupon.

4. All of the following may serve to reduce the coupon rate that would otherwise be required on a bond issued at par, except a a. b. c. d. e. Sinking fund. Restrictive covenant. Call provision. Change in rating from Aa to Aaa. None of the above (all may reduce the required coupon rate).

5. A 10-year bond has a 10 percent annual coupon and a yield to maturity of 12 percent. The bond can be called in 5 years at a call price of $1,050 and the bonds face value is $1,000. Which of the following statements is most correct? a. b. c. d. e. f. The bonds current yield is greater than 10 percent. The bonds yield to call is less than 12 percent. The bond is selling at a price below par. Both answers a and c are correct. None of the above answers is correct.

6. Assume that you are considering the purchase of a $1,000 par value bond that pays interest of $70. each six months and has 10 years to go before it matures. If you buy this bond, you expect to hold it for 5 years and then to sell it in the market. You (and other investors) currently require a nominal annual rate of 16 percent, but you expect the market to require a nominal rate of only 12 percent when you sell the bond due to a general decline in interest rates. How much should you be willing to pay for this bond? a. b. c. d. e. $842.00 $1,115.81 $1.359.26 $966.99 $731.85

7. Kennedy Gas Works has bonds which mature in 10 years, and have a face value of $1,000. . The bonds have a 10 percent quarterly coupon (i.e., the nominal coupon rate is 10 percent). The bonds may be called in five years. The bonds have a nominal yield to maturity of 8 percent and a yield to call of 7.5 percent. What is the call price on the bonds? a. b. c. d. e. 8. $ 379.27 $1,025.00 $1,048.34 $1,036.77 $1,136.78

Bankruptcy Re-Org and Debt Re-Structuring Recently, Ohio Hospitals, Inc. filed for bankruptcy. The firm was reorganized as American Hospitals, Inc., and the court permitted a new indenture on an outstanding bond issue to be put into effect. The issue has 10 years to maturity and a coupon rate of 10 percent, paid annually. The new agreement allows the firm to pay no interest for 5 years. Then, interest payments will be resumed for the next 5 years. Finally, at maturity (Year 10), the principal plus the interest that was not paid during the first 5 years will be paid. However, no interest will be paid on the deferred interest. If the required annual return is 20 percent, what should the bonds sell for in the market today?

9. Zero Coupon Bonds Suppose your company needs to raise $10 million and you want to issue 20-year bonds for this purpose. Assume the required return on your bond issue will be 9 percent, and youre evaluating two issue alternatives: a 9 percent annual coupon bond, and a zero coupon bond. Your companys tax rate is 35 percent. a. How many of the coupon bonds would you need to issue to raise the $10 million? How many of the zeroes would you need to issue? b. In 20 years, what will your companys repayment be if you issue the coupon bonds? What if you issue the zeroes?

c. Consider the firms after tax cash flow for the first year under the two scenarios. Why would you want to ever issue zero coupon bonds? 10. Bond vs. Mortgage Suppose Hadden Inc. is negotiating with an insurance company to sell it a bond issue. Each bond has a par value of $1,000, it would pay 10% per year in quarterly payments of $25 per quarter for 10 years, and then it would pay 12% per year ($30 per quarter) for the next 10 years (Years 1120). The $1,000 principal would be returned at the end of 20 years. The insurance companys alternative investment is in a 20-year mortgage which has a nominal rate of 14 percent and which provides monthly payments. If the mortgage and the bond issue are equally risky, how much should the insurance company be willing to pay Hadden for each bond?

11. MV of Debt In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures to a market value basis. KJM Corporation's balance sheet as of today, January 1,2009 is as follows: Long-term Debt (bonds, at par) $10,000,000 Preferred stock 2,000,000 Common Stock ($10 par) 10,000,000 Retained Earnings 4,000,000 Total Debt & Equity $26,000,000 The bonds have a 4 percent coupon rate, payable semiannually, and a par value of $1,000. They mature on January 1, 2019. The yield to maturity is 12%. What is the current market value of the firm's debt?

12. Comparing Bond Prices Assume McDonald's and Burger King have similar $1,000 par value bond issues outstanding. The bonds are equally risky. The Burger King bond has an annual coupon rate of 8% and matures 20 years from today. The McDonald's bond has a coupon rate of 8 percent with interest paid semiannually, and it also matures in 20 years. If McDonald's has a nominal required rate of return of 12% on its semiannual basis bonds, and Burger King has the equivalent annual rate on its bonds, what is the difference in current market prices of the two bonds?

13. Refinancing Bonds and ROE Aurillo Equipment Company (AEC) projected that its ROE for next year would be just 6 percent. However, the financial staff has determined that the firm can increase its ROE by refinancing some high interest bonds currently outstanding. The firm's total debt will remain at $200,000 and the debt ratio will hold constant at 80 percent, but the interest rate on the refinanced debt will be 10 percent. The rate on the old debt is 14 percent. Refinancing will not affect sales which are projected to be $300,000. EBIT will be 11

percent of sales, and the firm's tax rate is 40 percent. If AEC refinances its high interest bonds, what will be its projected new ROE? Interest Rates: Inflation & Maturity Risk (#s 9 & 10) 9. Assume the real risk-free rate (r*) is 4% and inflation is expected to be 7 percent in Year1; 4% in yr 2; and 3% thereafter. Assume all Treasury Bonds are highly liquid and free of default risk. If 2-yr and 5-yr T-Bonds both yield 11%, what is the difference in the maturity risk premiums (MRPs) on the two bonds; that is, what is MRP5 MRP2?

10. Due to the recession, the rate of inflation expected for the coming year is only 3.5%. However, the rate of inflation in Yr 2 and thereafter is expected to be constant at some level above 3.5%. Assume the real risk-free rate (r*) = 2% for all maturities, and there are no maturity premiums. If 3-year T-Bonds yield 3% (0.03) more than the 1-year T-Bonds, what rate of inflation is expected after year 1?

ProbSet Chapter 5 (13e) Bond Valuation & Interest Rates INTEREST RATES 1. If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond? a. The yield on the 10-year bond is less than the yield on a 1-year bond. b. The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity risk premiums. c. It is impossible to tell without knowing the coupon rates of the bonds. d. The yield on the two bonds are equal. e. It is impossible to tell without knowing the relative risks of the two bonds.

2. The real risk-free rate of interest, k*, is expected to remain constant at 3 percent. Inflation is expected to be 3 percent for the next year and then 2 percent a year thereafter. The maturity risk premium risk is zero. Given this information, which of the following statements is most correct? a. The yield curve for U.S. Treasury securities is downward sloping. b. A 5-year corporate bond has a higher yield than a 5-year Treasury security. c. A 5-year corporate bond has a higher yield than a 7-year Treasury security. d. Statements a and b are correct. e. All of the above statements are correct.

3. For the foreseeable future, the real risk-free rate of interest, k*, is expected to remain at 3 percent. Inflation is expected to steadily increase over time. The maturity risk premium equals 0.1 (t 1)%, where t represents the bonds maturity. On the basis of this information, which of the following statements is most correct? a. The yield on a 10-year Treasury securities must exceed the yield on a 2-year Treasury securities. b. The yield on a 10-year Treasury securities must exceed the yield on a 5-year corporate bonds. c. The yield on a 10-year corporate bonds must exceed the yield on a 8-year Treasury securities. d. Statements a and b are correct. e. Statements a and c are correct.

Which of the following is likely to increase the level of interest rates in the economy? a. Households start saving a larger percentage of their incomes. b. Corporations step up their plans for expansion and increase their demand for capital. c. The level of inflation is expected to decline. d. All of the statements above are correct. e. None of the statements above are correct.

5. Which of the following statements regarding term structure of interest rates is most accurate? a. The maturity premiums reflected 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 than on shortterm bonds. b. Reinvestment rate risk is lower, other things held constant, on long-term than on shortterm bonds. c. Under expectations theory of interest rates, there are separate markets for borrowers and savers (lenders). That is, borrowers prefer to borrow short term, while lenders prefer to have their money invested long term, creating an upward sloping yield curve. d. If the maturity risk premium were zero, and interest rates were expected to decrease in the future, then the yield curve of U.S. Treasury Bonds would have an upward slope, all other things constant. e. None of the above is correct. 6. The following are interest rates for 30-year corporate and government debt instruments T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were caused primarily by a. b. c. d. e. Tax effects differences Default risk differences Maturity risk differences Inflation differences Both B & D are correct

7. Amgen just issued bonds to mature in 10 years. Genentech just issued bonds to mature to mature in 12 years. Both are standard coupon bonds that cannot be retired early. The two bonds are equally liquid. Which of the following regarding yield curves is most accurate? a. If the yield curve for Treasuries is flat, Amgens bond will have the same as Genentechs. b. If the yield curve for Treasuries is upward sloping, Genentechs bonds will have a higher yield than Amgens. c. If the two bonds have the same level of default risk, their yields will also be the same. d. If the Treasury yield curve is upward sloping and Amgen has less default risk than Genentech, then Amgens bonds will have a lower yield. e. If the Treasury yield curve is downward sloping, Genentechs bonds will have a lower yield. 8. One-year Treasury securities yield 6.9%, while two-year Treasuries yield 7.2%. Given a maturity risk premium = 0 under expectations, what does the market anticipate to be the yield on one-year Treasuries one-year from now? a. b. c. d. 6.0% 6.7% 7.2% 7.5%

e. 8.0% 9. One-year Treasury securities yield 5 percent, 2-year Treasury securities yield 5.5 percent, and 3-year Treasury securities yield 6 percent. Assume that the expectations theory hold. What does the market expect will be the yield on 1-year Treasury securities two years from now? a. 6.0% b. 6.5% c. 7.0% d. 7.5% e. 8.0% 10. The real risk-free rate of interest, k*, is 4 percent, and it is expected to remain constant over time. Inflation is expected to be 2 percent per year for the next three years, after which time inflation is to remain at a constant rate of 5 percent per year. The maturity risk premium is equal to 0.1(t 1)%, where t = the bonds maturity. What is the yield on a 10-year Treasury bond? a. 8.1% b. 8.9% c. 9.0% d. 9.1% e. 9.9% 11. Given the following data, find the expected rate of inflation during the next year. k* - real risk-free rate = 3%. Maturity risk premium on 10-year T-bonds = 2%. It is zero on 1-year bonds, and a linear relationship exists. Default risk premium on 10-year, A-rated bonds = 1.5%. Liquidity premium = 0%. Going interest rate on 1-year T-bonds = 8.5%. a. b. c. d. e. 3.5% 4.5% 5.5% 6.5% 7.5%

12. A fixed-income analyst has made the following assessments: The real risk-free rate is expected to remain at 2.5 percent for the next ten years. Inflation is expected to be 3 percent this year, 4 percent next year, and 5 percent thereafter. The maturity risk premium is 0.1%(t 1), where t = the maturity of the bond (in years). A 5-year corporate bond currently yields 8.5%. What will be the yield on the bond, one year from now, if the above assessments are correct, and the bonds default premium and liquidity premium remain unchanged? a. 7.30% b. 8.40% c. 8.50% d. 8.75% e. 8.85%

Corp Fin Answers: Ch 5 Bonds 1. 2. 3. 4. 5. 6. 7. 8. 9. E B C C D D C $362.44 a) 10,000; 56,044 b) $10,900,000; $56,044,000 c) <$585,000>; $315,023 10. $750.78 11. $5,412,000 12. $17.53 13. 15.6% Ch 5 Interest Rates 1. A 2. E 3. E 4. B 5. B 6. B 7. D 8. D 9. C 10. C 11. C 12. D