Chapter 5 Bonds

Question 1

DuPont System of Analysis

Answer 1

DuPont System of Analysis is an integrative approach used to dissect a firm’s financial statements and assess its financial condition
It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE

Question 2

In the DuPont System the firm’s return is broken into three components

Answer 2

A profitability measure (net profit margin)
An efficiency measure (total asset turnover)
A leverage measure (financial leverage multiplier)

Question 3

Bond indenture

Answer 3

Major provisions/ agreement
 Over 100 pages long
 Complicated legal document
 Administered by a trustee
    (usually a commercial bank)

Question 4

Par value

Answer 4

Face value of a bond
Corporate: $1,000
Fed, state, & local: $5,000 or $10,000

Question 5

Sinking-fund

Answer 5

Semiannual or annual contributions by the bond issuer into a fund run by a trustee for the purposes of debt retirement

Question 6

Debenture

Answer 6

Unsecured corporate debt issue

Higher yields due to higher risk

Question 7

Features of Preferred Stock

Answer 7

Convertible
May be converted into common stock

Callable
Generally slightly above par

Cumulative
If dividends not paid in any year, they accumulate and must be paid before common shareholders receive any cash dividend

Question 8

Nominal Yield

Answer 8

Measures the coupon rate

Question 9

Current yield

Answer 9

Measures current income rate

Question 10

Promised yield to maturity

Answer 10

Measures expected rate of return for bond held to maturity

Question 11

Promised yield to call

Answer 11

Measures expected rate of return for bond held to first call date

Question 12

Realized (horizon) yield

Answer 12

Measures expected rate of return for a bond likely to be sold prior to maturity.

Question 13

Expectations Theory

Answer 13

Term Structure and Capital Budgeting
CF should be discounted using term structure info
When rate incorporates all forward rates, use spot rate that equals project term
Take advantage of arbitrage

Question 14

Expectations Hypothesis

Answer 14

Any long-term rate is an average of the expectations of future short-term rates over the applicable time horizon

Question 15

Liquidity Preference Theory

Answer 15

The shape of the term structure curve tends to be upward sloping more than any other pattern.

Reflects recognition that long maturity obligations are subject to greater price-change movements when interest rates change

Question 16

Market Segmentation Theory

Answer 16

Banks prefer short-term liquid securities

Life insurance companies prefer long-term bonds

These two institutions often put pressure on short-term and long-term rates

Question 17

Bond Pricing Rules

Answer 17

Bond prices and interest rates are inversely related.

Prices of long-term bonds are more sensitive to change in YTM than short-term bonds.
Prices of low-coupon bonds are more sensitive to a change in YTM than high-coupon bonds.

Question 18

Factors affecting default risk and bond ratings

Answer 18

Financial performance
Debt ratio
TIE ratio
Current ratio
Bond contract provisions
Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity

Question 19

Priority of claims in liquidation

Answer 19

Secured creditors from sales of secured assets.
Trustee’s costs
Wages, subject to limits
Taxes
Unfunded pension liabilities
Unsecured creditors
Preferred stock
Common stock