Chapter 7

Question 1

Bond

Answer 1

Long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of a bond

Question 2

Key features of a bond

Answer 2

• Par value
• Coupon interest rate
• Maturity years
• Issue date
• Yield to maturity

Question 3

Par Value

Answer 3

Face amount of bond, paid at maturity

Question 4

Coupon Interest Rate

Answer 4

-Stated interest rate (generally fixed) paid by the issuer

**Multiply by par value to get $ payment of interest

Question 5

Maturity Years

Answer 5

Years until the bond must be repaid

Question 6

Issue Date

Answer 6

When the bond was issued

Question 7

Yield to Maturity

Answer 7

-Rate of return earned on a bond held until maturity, “promised yield”

**Par/Discount bonds

Question 8

Convertible Bonds

Answer 8

May be exchanged for common stock of the firm, at the holders option

Question 9

Warrant

Answer 9

Long-term option to buy a stated number of shares of common stock at a specified price

Question 10

Puttable Bond

Answer 10

Allows holder to sell the bond back to the company prior to maturity

Question 11

Income Bond

Answer 11

Pays interest only when interest is earned by the firm

Question 12

Indexed Bond

Answer 12

Interest rate paid is based upon the rate of inflation

Question 13

Call Provision

Answer 13

• Allows issuer to refund bond issue if rates decline
• Require higher yields on callable bonds
• Include a deferred provision and a declining premium

Question 14

Registered Bond

Answer 14

Name of bondholder is registered with the issuer; identity known

Question 15

Bearer Bond

Answer 15

Issuer has no record of the name of the investor; investor anonymous

Question 16

Sinking Fund

Answer 16

• Provision to pay off a loan over its life rather than all at maturity
• Similar to amortization on a long-term loan
• Reduces risk to investor, shortens average maturity
• But not good for investors if rates decline after issuance—– because they can call the bond and reissue it at a lower interest rate, so they pay less

Question 17

How are sinking funds executed?

Answer 17

• Call X% of the issue at par for sinking funds
• —Likely to be used if the bond sells at a premium
• Buy bonds in the open market
• —Likely to be used if the bond sells at a discount

Question 18

Premium

Answer 18

Greater than par value

Question 19

Discount

Answer 19

Less than par value

Question 20

Opportunity Cost of Debt Capital

Answer 20

Rate that could be earned on an alternative investment

Question 21

Expected Return

Answer 21

(Coupon payment + capital gain (loss))/Original investment

Question 22

Current Yield

Answer 22

Annual coupon payment/Current Price

Question 23

Capital Gains Yield

Answer 23

Change in Price/Beginning Price

Question 24

Expected Total Return=YTM

Answer 24

• Expected CY+Expected CGY

- CGY=YTM-CY

Question 25

Price Risk

Answer 25

• The concern that rising cost of debt will cause the value of the bond to fall
• A 10 year bond would be more sensitive to interest payments compared to a 1 year bond; 10 year bond has higher price risk

Question 26

Reinvestment Risk

Answer 26

Interest rate will fall and reduce return

Question 27

Semiannual Bonds

Answer 27

• Paid twice a year, every 6 months
• Multiply number of periods by 2 (2N)
• Divide nominal rate by 2, periodic rate=(i/2)
• Divide coupon rate by 2, payment=(annual coupon/2)

Question 28

Yield to Call

Answer 28

-The rate of return earned on a bond when it is called before its maturity date

**Premium bonds

Question 29

Bond Ratings

Answer 29

Designed to reflect the probability of a bond issue going into default

Question 30

Moody’s

Answer 30

• Investment Grade: Aaa, Aa, A, Baa

- Junk Bonds: Ba, B, Caa, C

Question 31

S&P

Answer 31

• Investment Grade: AAA, AA, A, BBB

- Junk Bonds: BB, B, CCC, C

Question 32

Factors Affecting Default Risk and Bond Ratings (Financial Performance)

Answer 32

• Debt Ratio
• TIE Ratio
• Current Ratio

Question 33

Factors Affecting Default Risk and Bond Ratings (Qualitative)

Answer 33

• Secured vs. Unsecured debt
• Senior vs. Unsubordinated debt
• Guarantee and sinking fund provisions
• Debt maturity

Question 34

Miscellaneous Qualitative Factors

Answer 34

• Earnings stability
• Regulatory environment
• Potential antitrust or product liabilities
• Pension liabilities
• Potential labor problems

Question 35

Bankruptcy (Chapter 11)

Answer 35

• To stop creditors from foreclosing, taking assets, and closing the business and it has 120 days to file a reorganization plan.
• Court appoints a “trustee” to supervise reorganization
• Management usually stays in control.Company must demonstrate in its reorganization plan that it is “worth more alive than dead.”
• If not, judge will order liquidation under Chapter 7.

Question 36

Bankruptcy (Chapter 7)

Answer 36

1. Secured creditors from sales of secured assets
2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock