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4/26/2014
FIN 534 Homework Chapter 5
1. Ranger Inc. would like to issue new 20-year bonds. Initially, the plan was to
make the bonds non-callable. If the bonds were made callable after 5 years at a
5% call premium, how would this affect their required rate of return?
ANSWER c. The required rate of return would increase because the bond would then
be more risky to a bondholder.
Explanation: Most corporate bonds contain a call provision, which gives the issu
ing corporation the right to call the bonds for redemption. The call provision g
enerally states that the company must pay the bondholders an amount greater than
the par value if they are called. The additional sum is called a call premium (
Brigham & Ehrhardt, 2014). If the bonds were made callable after 5 years and inc
reased with the call premium, then the rate of return would also increase becaus
e the bond is more risky (or cost more) to the bondholder.
2. Under normal conditions, which of the following would be most likely to incre
ase the coupon rate required to enable a bond to be issued at par?
ANSWER a. Adding a call provision.
Explanation: On page 192 of our book, The call provision generally states that th
e company must pay the bondholders an amount greater than the par value if they
are called (Brigham & Ehrhardt, 2014).
3. Which of the following bonds would have the greatest percentage increase in v
alue if all interest rates fall by 1%?
ANSWER d. 20-year, zero coupon bond. e. 10-year, zero coupon bond.
Explanation: Our book states, Interest rates go up and down over time, and an inc
rease in interest rates leads to a decline in the value of outstanding bonds. Th
is risk of a decline in bond value due to rising interest rate is called interes
t rate risk (Brigham & Ehrhardt, 2014). Inversely, a decrease in interest rates l
eads to an increase in the bond value. Our books continues to state that For bond
s with similar coupons, this differential sensitivity to changes in interest rat
es always holds true: The longer the maturity of the bond, the more its price ch
anges in response to a given change in interest rates (Brigham & Ehrhardt, 2014).
The zero coupon bond means that the there are no payments until maturity and the
duration is equal to its maturity.
4. Assume that all interest rates in the economy decline from 10% to 9%. Which o
f the following bonds would have the largest percentage increase in price?
ANSWER c. A 10-year zero coupon bond.
Explanation: Our book states, Interest rates go up and down over time, and an inc
rease in interest rates leads to a decline in the value of outstanding bonds. Th
is risk of a decline in bond value due to rising interest rate is called interes
t rate risk (Brigham & Ehrhardt, 2014). Inversely, a decrease in interest rates l
eads to an increase in the bond value. Our books continues to state that For bond
s with similar coupons, this differential sensitivity to changes in interest rat
es always holds true: The longer the maturity of the bond, the more its price ch
anges in response to a given change in interest rates (Brigham & Ehrhardt, 2014).
The zero coupon bond means that the there are no payments until maturity and the
duration is equal to its maturity.
5. Which of the following bonds has the greatest interest rate price risk?
ANSWER a. A 10-year, $1,000 face value, zero coupon bond.
Explanation:Our book states, Interest rates go up and down over time, and an incr
ease in interest rates leads to a decline in the value of outstanding bonds. Thi
s risk of a decline in bond value due to rising interest rate is called interest
rate risk (Brigham & Ehrhardt, 2014). Inversely, a decrease in interest rates le
ads to an increase in the bond value. Our books continues to state that For bonds
with similar coupons, this differential sensitivity to changes in interest rate
s always holds true: The longer the maturity of the bond, the more its price cha
nges in response to a given change in interest rates (Brigham & Ehrhardt, 2014).
The zero coupon bond means that the there are no payments until maturity and the d
uration is equal to its maturity.
Brigham, E., & Ehrhardt, M. (2014). Financial management. (14th ed.). Mason, Ohi
o: Cengage Learning.