Chapter 18

Question 1

1) Which of the following has the characteristics of a fixed contractual commitment?

a) Long-term debt
b) Common stock dividends
c) Preferred stock
d) Retained earnings

Answer 1

a

Question 2

2) Which of the following represents tax-deductible expenses?
I. Rental on office building
II. Interest expense
III. Preferred stock dividends
IV. Common stock dividends

a) I and II
b) I, II and III
c) III only
d) III and IV

Answer 2

a

Question 3

3) Toronto Skaters has issued $100 million in bonds paying 6% interest per year. The firm has a tax rate of 45%. The firm’s annual interest payments are __________ and the after-tax cost of the debt is _______________ per year.

a) $6 million, $6 million
b) $6 million, $2.7 million
c) $6 million, $3.3 million
d) $3.3 million, $2.7 million

Answer 3

c

Question 4

4) Laurentide Ski Resort has to make a choice between two different debt issues. Issue 1 has an interest rate of 5% and the interest is tax deductible. Issue 2 has an interest rate of 4% but the interest is not tax deductible. If the firm has a tax rate of 40%, which issue is preferred and why?

a) Issue 2 because the interest rate of 4% is less than the 5% of issue 1.
b) Issue 1 because the after-tax cost is 3% while the after-tax cost of issue 2 is 4%
c) Issue 1 because the after-tax cost is 2% while the after-tax cost of issue 2 is 4%
d) Issue 2 because the after-tax cost is 1.6% while the after-tax cost of Issue 1 is 2%

Answer 4

b

Question 5

5) Use the following statements to answer this question:
I. Tax deductibility of dividends makes equity very desirable.
II. An instrument can be classified as debt even if it is not so in the Income Tax Act.

a) I and II are correct
b) I and II are incorrect
c) I is incorrect and II is correct
d) I is correct and II is incorrect

Answer 5

b

Question 6

6) Generally, any debt instrument with a maturity of less than one year is called a _________, from one to seven years is called a _____________, and more than seven years is called a ______________.

a) Bond, Bill, Note
b) Bill, Bond, Note
c) Note, Bill, Bond
d) Bill, Note, Bond

Answer 6

d

Question 7

7) A treasury bill (T-bill) is a _____________ issued by __________________.

a) Short-term promissory note, high quality Canadian firms
b) Bond, high quality Canadian firms
c) Short-term promissory note, a government treasury department
d) Bond, the government of Canada

Answer 7

c

Question 8

8) T-bill yields are quoted on a __________ basis.

a) Compound interest
b) After-tax
c) Discount
d) None of the above

Answer 8

c

Question 9

9) A Government of Canada T-bill with a face value of $1,000 and 45 days to maturity is trading for $985.22. The 45-day interest rate is _________ and the annual rate is ___________.

a) 1.5%, 12.17%
b) 12.17%, 1.5%
c) 1.5%, 12.84%
d) 12.84%, 1.5%

Answer 9

a

Question 10

10) Laurentide Resorts is issuing a commercial paper with 60 days to maturity. In case of default, the investor will lose the total amount. The quoted rate for the issue is 7 percent, and an equivalent government-backed security’s rate is 6 percent. What is the probability of default?

a) 0%
b) 0.94%
c) 1%
d) 99.06%

Answer 10

b

Question 11

11) Laurentide Resorts is issuing commercial paper with 60 days to maturity. In case of default, the investor will receive 40 cents on the dollar. The quoted rate for the issue is 7 percent, and an equivalent government-backed security’s rate is 6 percent. What is the probability of default?

a) 0%
b) 0.94%
c) 1%
d) 1.49%

Answer 11

d

Question 12

12) Saskatchewan Wheat Fields Inc. is planning to issue $100 million of commercial paper with 30 days to maturity. The quoted rate for the issue is 8%. There is a 3% probability that the firm will default on the issue and the investor will receive zero. If the investor’s required rate of return is 5%, then the value of the issue is:

a) $100 million
b) $99.77 million
c) $99.59 million
d) $97.24 million

Answer 12

d

Question 13

13) Saskatchewan Wheat Fields Inc. is planning to issue $100 million of commercial paper with 30 days to maturity. There is a 1% probability that the firm will default on the issue and the investor will receive zero. The investor’s required rate of return is 5%. If the firm wishes to issue the commercial paper at par, the promised yield must be:

a) 17.17%
b) 5%
c) 8.25%
d) 42.27%

Answer 13

a

Answer: a, [(1+0.05/12)/(1-1%)-1]*12=17.17%

Question 14

14) Saskatchewan Wheat Fields Inc. is planning to issue $100 million of commercial paper with 30 days to maturity. There is a 3% probability that the firm will default on the issue and the investor will receive $40 million (or 40 cents on the dollar). The investor’s required rate of return is 5%. If the firm wishes to issue the commercial paper at par, the promised yield must be:

a) 2.29%
b) 7.01%
c) 27.42%
d) 42.27%

Answer 14

c

Question 15

15) Bond rating services:

a) Evaluate credit or default risk.
b) Can affect bond prices by the ratings they give.
c) Classify Government of Canada bonds as nearly default risk free.
d) All of the above

Answer 15

d

Question 16

16) The promised yield on bankers’ acceptances is typically _______ than the promised yield on the commercial paper of similar firms because _______________.

a) Higher; banks charge a fee to accept or guarantee the debt
b) Lower; banks charge a fee to accept or guarantee the debt
c) Higher; the banks that guarantee the debt are more creditworthy than the issuing firm
d) Lower; the banks that guarantee the debt are more creditworthy than the issuing firm

Answer 16

d

Question 17

17) The issuer of bankers’ acceptances is paying a promised yield of 5 percent. What would be the promised yield on securities of the bank guaranteeing this issue?

a) Equivalent or less than 5%
b) Higher than 5%
c) Depends on the bank’s liquidity
d) Cannot be determined

Answer 17

a

Question 18

18) Use the following statements to answer this question:
I. The major implication of backing money market funds by risky assets is an increase in money market spreads.
II. Bankers’ acceptances yields are always lower than commercial paper yields.

a) I and II are correct
b) I and II are incorrect
c) I is incorrect and II is correct
d) I is correct and II is incorrect

Answer 18

a

Question 19

19) The purpose of a covenant is to:

a) protect the lender in the event of default by the borrower.
b) protect the borrower in the event of increasing product market competition.
c) protect the borrower in the event of default by the lender.
d) protect the borrower in the event of a deterioration of the credit quality of the lender.

Answer 19

a

Question 20

20) In general, a line of credit has a _____________ maturity while a term loan has a _________ maturity.

a) fixed; floating
b) floating; fixed
c) fixed; fixed
d) floating; floating

Answer 20

b

Question 21

21) In general a “floating rate” on a debt issue refers to:
I. Variable payment times for the interest payments
II. Variable interest payments
III. Yield on the debt equals the average dividend yield on the Toronto Stock Exchange

a) I and II
b) II
c) II and III
d) I and III

Answer 21

b

Question 22

22) Which of the following is the least important for assessing the company’s profile for a letter of credit?

a) Current ratio
b) Debt to equity ratio
c) Price to earnings ratio
d) Receivable turnover

Answer 22

c

Question 23

23) Which one of the following does not explain why banks enjoy lower asymmetry of information?

a) The bank has access to the firm’s financial activity.
b) The company relies on the bank for financing and other hedging activities.
c) The company is required by law to give the bank access to privileged information.
d) The company provides information to negotiate banking products.

Answer 23

c

Question 24

24) A typical five-year revolving line of credit is characterized by:

a) A fixed interest rate for the five years.
b) A floating interest rate, renewed periodically during the five-year term.
c) An interest rate that is lower than the prime rate because these lines of credit are only offered to the most creditworthy firms.
d) b and c

Answer 24

b

Question 25

25) Junk bonds are:

a) speculative bonds with ratings below investment grade;
b) subordinated debentures
c) a nickname for bonds traded in the Hong Kong market
d) corporate bonds of bankrupt companies

Answer 25

a

Question 26

26) When specific assets such as land, plant, or equipment are pledged as collateral, what is the term for the debt issue?

a) debenture
b) mortgage bond
c) bond
d) secured debt

Answer 26

b

Question 27

27) Choose the best statement:

a) Mortgage bonds and debentures do not differ because they are both debt.
b) In the event of bankruptcy, debenture holders get paid after the claims of preferred shareholders.
c) Mortgages are secured by claims on specific real assets while debentures are not.
d) Debentures are secured by claims on specific real assets while mortgages are not.

Answer 27

c

Question 28

28) The North American Bat Experts Company (NABE) has just sold a batting machine to a Jamaican cricket team. The team will pay for the machine by borrowing the money from NABE and securing the loan using the machine. This type of debt is called:

a) Debenture
b) Acceptance
c) Purchase-money mortgage
d) Line of credit

Answer 28

c

Question 29

29) Rank the following in order of priority in the event of bankruptcy:
I. Subordinated, secured debt
II. Subordinated, unsecured debt
III. Unsubordinated, secured debt
IV. Unsubordinated, unsecured debt

a) III, I, IV, II
b) IV, I, III, II
c) III, IV, I, II
d) IV, II, III, I

Answer 29

a

Question 30

30) The Toronto Skaters Company currently has one issue of debt outstanding. Toronto Skaters has decided to borrow more money by issuing new debt with a higher priority in the event of bankruptcy. This could result in a violation of which type of covenant on the original debt?

a) Standard negative pledge
b) Cross-default clause
c) The new issue will not violate any covenant as there are never covenants when a firm has only one issue of debt
d) This type of transaction is illegal

Answer 30

a

Question 31

31) A junk bond is also known as:

a) a second mortgage
b) a high yield bond
c) a line of credit
d) a subordinated unsecured bond

Answer 31

b

Question 32

32) Use the following statements to answer this question:
I. The debt rating is supposed to fluctuate with the economic cycle.
II. Balance sheet strength refers to the ability of the firm to cover its liabilities.

a) I and II are correct
b) I and II are incorrect
c) I is incorrect and II is correct
d) I is correct and II is incorrect

Answer 32

c

Question 33

33) A bond referred to as a “high yield bond” is most likely:

a) of the highest credit quality
b) of investment grade
c) of satisfactory credit quality
d) of speculative grade

Answer 33

d

Question 34

34) Is it possible for a company to have two debt issues with different debt ratings?

a) No, the rating agency evaluates the creditworthiness of the company.
b) Yes, but only if the company is a multinational and the debt has been issued in different countries.
c) No, the company’s credit is the same for all bonds.
d) Yes, the rating agency evaluates the creditworthiness of the issue, not the company.

Answer 34

d