Course name: Foundations of Financial Management (10248) – Fall I, 2013

Assignment name: Week 4 Questions/Problems

1. Which of the following statements is CORRECT?

a. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond.

b. A bond’s current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate.

c. If a bond sells at par, then its current yield will be less than its yield to maturity.

d. If a bond sells for less than par, then its yield to maturity is less than its coupon rate.

e. A discount bond’s price declines each year until it matures, when its value equals its par value.

2. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT?

a. The price of Bond A will decrease over time, but the price of Bond B will increase over time.

b. The price of Bond B will decrease over time, but the price of Bond A will increase over time.

c. The prices of both bonds will remain unchanged.

d. The prices of both bonds will increase by 7% per year.

e. The prices of both bonds will increase over time, but the price of Bond A will increase by more.

Problem 5-2

Yield to Maturity for Annual Payments

3. Wilson Wonders’s bonds have 15 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 12%. The bonds sell at a price of $1,100. What is their yield to maturity? Round your answer to two decimal places.

%

Problem 5-6

Maturity Risk Premium

4. The real risk-free rate is 2%, and inflation is expected to be 4% for the next 2 years. A 2-year Treasury security yields 7.8%. What is the maturity risk premium for the 2-year security?

%

Problem 5-4

Determinant of Interest Rates

5. The real risk-free rate is 4%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero.

What is the yield on 2-year Treasury securities? Round your answer to two decimal places.

%

What is the yield on 3-year Treasury securities? Round your answer to two decimal places.

%

Problem 5-19

Maturity Risk Premiums

6. Assume that the real risk-free rate, r*, is 3% and that inflation is expected to be 7% in Year 1, 6% in Year 2, and 4% thereafter. Assume also that all Treasury securities are highly liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10%, what is the difference in the maturity risk premiums (MRPs) on the two notes; that is, what is MRP5 minus MRP2? Round your answer to two decimal places.

%

7. Which of the following statements is CORRECT?

a. You hold two bonds. One is a 10-year, zero coupon, issue and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the larger percentage decline.

b. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates.

c. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates.

d. You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline.

e. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates.

8. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price?

a. An 8-year bond with a 9% coupon.

b. A 10-year zero coupon bond.

c. A 1-year bond with a 15% coupon.

d. A 10-year bond with a 10% coupon.

e. A 3-year bond with a 10% coupon.

Problem 5-20

Inflation Risk Premiums

9. Because of a recession, the inflation rate expected for the coming year is only 4%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 4%. Assume that the real risk-free rate is r* = 2% for all maturities and that there are no maturity premiums. If 3-year Treasury notes yield 2 percentage points more than 1-year notes, what inflation rate is expected after Year 1?

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10. Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds?

a. The company’s bonds are downgraded.

b. Market interest rates decline sharply.

c. Inflation increases significantly.

d. The company’s financial situation deteriorates significantly.

e. Market interest rates rise sharply.

11. Tucker Corporation is planning 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?

a. Because of the call premium, the required rate of return would decline.

b. The required rate of return would increase because the bond would then be more risky to a bondholder.

c. The required rate of return would decline because the bond would then be less risky to a bondholder.

d. There is no reason to expect a change in the required rate of return.

e. It is impossible to say without more information.

12. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT?

a. The bond’s current yield is greater than 9%.

b. If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price.

c. The bond is selling below its par value.

d. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price.

e. The bond is selling at a discount

Problem 5-1

Bond Valuation with Annual Payments

13. Jackson Corporation’s bonds have 13 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 11%. The bonds have a yield to maturity of 10%. What is the current market price of these bonds? Round your answer to the nearest cent.

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Problem 5-7

Bond Valuation with Semiannual Payments

14. Renfro Rentals has issued bonds that have a 12% coupon rate, payable semiannually. The bonds mature in 15 years, have a face value of $1,000, and a yield to maturity of 10%. What is the price of the bonds? Round your answer to the nearest cent.

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Problem 5-14

Current Yield with Semiannual Payments

15. A bond that matures in 9 years sells for $950.The bond has a face value of $1,000 and a yield to maturity of 9.8764%. The bond pays coupons semiannually. What is the bond’s current yield? Round your answer to two decimal places.

%

Problem 5-8

Yield to Maturity and Call with Semiannual Payments

16. Thatcher Corporation’s bonds will mature in 10 years. The bonds have a face value of $1,000 and an 8% coupon rate, paid semiannually. The price of the bonds is $1,100. The bonds are callable in 5 years at a call price of $1,050. Round your answers to two decimal places.

What is their yield to maturity?

%

What is their yield to call?

%

17. Which of the following statements is CORRECT?

a. A sinking fund provision makes a bond more risky to investors at the time of issuance.

b. If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price.

c. Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature.

d. Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time.

e. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued.

Problem 5-8

Yield to Maturity and Call with Semiannual Payments

18. Thatcher Corporation’s bonds will mature in 10 years. The bonds have a face value of $1,000 and an 8% coupon rate, paid semiannually. The price of the bonds is $1,100. The bonds are callable in 5 years at a call price of $1,050. Round your answers to two decimal places.

What is their yield to maturity?

%

What is their yield to call?

%