Chapter 12 Part 4

Question 1

Mortgage bonds are secured by

Answer 1

a first or second mortgage on real property (either land or buildings). The bondholders have a lien on the property. The first mortgage bondholders have a first (senior) lien on the property. The second mortgage bondholders have the second (junior) lien. To protect the bondholders, the total par value of all the outstanding mortgage bonds should be less than the value of the property

Question 2

Equipment Trust Certificates

Answer 2

These bonds are secured by a piece of equipment. They are usually issued by transportation companies (railroads, airlines, and shipping companies). Historically, equipment trust certificates have been very safe investments, since the equipment is usually worth more than the bonds

Question 3

Collateral trust bonds

Answer 3

are secured by the stock or bonds of another company (not the issuer). Usually, the other corporation is an affiliate or a subsidiary of the issuing corporation

Question 4

Most corporate bonds are secured only by the

Answer 4

corporation’s promise to pay (good faith). not by a specific piece of corporate properly.

Question 5

debentures

Answer 5

Unsecured bonds are called debentures. If the issuer defaults, the owners of debentures have the same claim on the company’s assets as any other general creditor-before the stockholders, but after any secured bondholders

Question 6

subordinated debentures

Answer 6

Sometimes companies issue unsecured bonds that have a junior claim on their assets, compared to the bonds that they have already issued. These are called subordinated debentures. The claims of these new bondholders on the company’s assets are subordinated to those of the existing bondholders. In case the company goes bankrupt, the owners of the subordinated debentures will be paid after the other bondholders but before the stockholders

Question 7

Since convertible bonds are generally unsecured, they are actually a type of

Answer 7

debenture or subordinated debenture

Question 8

Convertible bonds are similar to

Answer 8

convertible preferred stock. (See Chapter 11.) They allow investors to convert their bonds into shares of the company’s common stock at a predetermined ratio. Since convertible bonds have this extra feature, companies can issue them at a lower interest rate than they would normally need to pay to attract investors

Question 9

Converting Bonds to Stock

Answer 9

The conversion price is set at the time the bonds are issued. To determine the number of shares of stock that a bondholder will receive if she converts her bonds, divide the par value of the bond ($1,000) by the conversion price. This becomes the conversion ratio

Question 10

For example, if an investor purchases 10% convertible subordinate debentures issued with a conversion price of $40, the conversion ratio is

Answer 10

25 shares for each bond

Question 11

Convertible bonds offer investors a greater degree of safety than preferred or common stock, but they also offer them the potential for greater

Answer 11

capital appreciation than nonconvertible bonds if the underlying stock does well

Question 12

A disadvantage of convertible bonds is that if all the bonds are converted into stock, the number of shares that the company has outstanding may

Answer 12

increase dramatically. This may cause dilution, a decrease in the value of the stockholder’s investment. In addition, the convertible bond pays a lower interest rate than comparable nonconvertible bonds

Question 13

The prices of corporate bonds are quoted as a

Answer 13

percentage of par value. The prices may be broken down into fractions such as 85 1/2 or 103 5/8

Question 14

To determine the dollar price of a corporate bond, you first

Answer 14

convert any fractions into decimals. Then multiply the percentage by the bond’s par value ($1,000).

Question 15

dollar cost of A corporate bond selling at 80 = 80%

Answer 15

Step 1: Convert 80% to a decimal = .80. Step 2: .80 x $1,000= $800. Step 2: .80 x$1,000= $800

Question 16

dollar cost of A corporate bond selling at 85 1/2

Answer 16

Step I: Convert 1/2 into a decimal by dividing 2 into 1. 1/2 = .5 Step 2: Convert 85.5% to a decimal = .855. Step 3: .855 x $1,000 = $855

Question 17

dollar cost of A corporate bond selling at 103 3/8

Answer 17

Step I: Convert 3/8 into a decimal. 3/8 = .375. Step 2: Convert 103.375% to a decimal= 1.03375 Step3: 1.03375 x $1,000=$1,033.75

Question 18

accrued interest

Answer 18

If a bondholder sells her bond before she receives her next interest payment, she is still entitled to the interest earned up until the time she sold the bond. The person who buys her bond will need to add the amount that the bondholder would have received to the price paid for the bond

Question 19

the interest on corporate bonds accrues on the basis of a

Answer 19

30-day month and a 360-day year

Question 20

The IRS treats the interest on corporate bonds the same way as dividends. Interest payments on corporate bonds are subject to

Answer 20

federal, state, and local inco1ne taxes as ordinary income. This means it is taxed in the year received at the investor’s tax bracket. Bond interest must be included on the investor’s tax returns the same year that it is received