Ch 7 - Bond Valuation

Question 1

Bond definition

Answer 1

Interest-only loan that the borrower pays the interest on every period and the principal is repaid at the end of the loan period

Question 2

Interest Rate Risk sensitivity factors (2)`

Answer 2

1. Time to Maturity: All else equal, the longer the time to maturity, the greater the interest rate risk
2. Coupon Rate: All else equal, the lower the coupon rate, the greater the interest rate risk

Question 3

Debt definition

Answer 3

Funds owed by the company towards another party called bondholders

Question 4

Debt features (4)

Answer 4

• bondholders do not have voting rights
• interest is considered a cost of doing business and is tax deductible
• bondholders have legal recourse if payments are missed
• excess debt leads to financial distress/bankruptcy

Question 5

Equity definition

Answer 5

Refers to an ownership interest (shareholders)

Question 6

Equity features (4)

Answer 6

• shareholders can vote
• dividends are not a cost of doing business, not tax deductible
• dividends are not a liability of the firm (no legal recourse if not paid)
• all-equity firm cannot go bankrupt

Question 7

Bond indenture

Answer 7

Contract between the company and the bondholders

Question 8

Bond indenture terms (2 + 4)

Answer 8

Required:
- basic terms of the bonds
- total amount of bonds issued
Additional:
- description of property used as security
- sinking fund provisions (part of the principal is paid alongside coupon)
- call provisions
- details of protective convenants

Question 9

Security types (4)

Answer 9

• Collateral: secured by financial securities
• Mortgage: secured by real property (land, buildings)
• Debentures: unsecured debt with of maturity of 10 yrs
• Notes: unsecured debt with maturity less than 10 yrs

Question 10

Seniority

Answer 10

Defines who gets first claim of remaining assets upon bankruptcy

Question 11

Callable bonds

Answer 11

Issuer is allowed to repurchase (“call”) part or all bonds at specified price over specified period

Question 12

Protective covenants

Answer 12

Limits placed to the company’s operations to reduce agency costs
- between shareholders (incentive for firm to engage in risky growth acts) and bondholders (incentive for firm to remain stable to pay bonds)

Question 13

Coupon rate depends on…

Answer 13

The risk characteristics of the bond when issued

Higher risk = higher coupon

Question 14

Bond Ratings

Answer 14

BBB and above: good investment quality
BB and below: speculative, junk bonds

Question 15

Stripped/zero coupon bonds (5)

Answer 15

• no periodic interest payments (0 coupon rate)
• YTM comes from difference between purchase price and par value
• cannot sell for more than par value
• zeros or deep discount bonds
• bondholder must pay taxes on accrued, but unreceived interest

Question 16

Floating rate bonds

Answer 16

Coupon rate floats depending on some index value (less susceptible to inflation)
- less price risk
- less likely to differ from YTM
- may have a collar or floor for the rate

Question 17

Real rate of interest

Answer 17

Compensation for change in purchasing power

Question 18

Nominal rate of interest

Answer 18

Quoted rate of interest, includes compensation for change in purchasing power and inflation

Question 19

Fisher Effect

Answer 19

(1+ nominal rate) = (1+ real rate)(1 + expected interest)