Module 5 - Interest Rates and Bond Valuation

Question 1

It is usually applied to debt instruments such as bank loans or bonds

Answer 1

Interest rate

Question 2

it is the compensation paid by the borrower of funds to the lender

Answer 2

interest rate

Question 3

it is usually applied to equity instruments such as common stock

Answer 3

required return

Question 4

the cost of funds obtained by selling an ownership interest

Answer 4

required return

Question 5

the cost of funds obtained by selling an ownershp interest

Answer 5

required return

Question 6

a company that plans a plant expansion can obtain financing either through:

Answer 6

debt or equity

Question 7

if the company issues bonds, they would have to pay the creditors the principal at a specified time

Answer 7

obtain financing through debt

Question 8

some companies raise capital through the issuance of shares

Answer 8

cimpanies obtaining financing through equity

Question 9

it is money lent at an interest rate for a certain period of time

Answer 9

Loan

Question 10

Content of a Loan Agreement: part of legal documentation. intended to protect investors by providing assurance on what the borrower will do or won’t do over the life of the bond

Answer 10

Covenants

Question 11

Content of a Loan Agreement: Pledge agreement, security agreement

Answer 11

Collateral

Question 12

Content of a Loan Agreement: Lump sum, semi-annual, monthly, etc.

Answer 12

Term of loan

Question 13

Content of a Loan Agreement: Provision in most loan and insurance contracts which allows payment to be received for a certain period of time after the actual due date

Answer 13

Grace Period

Question 14

Content of a Loan Agreement: during this period, no late fees will be charged, and the late payment will not result in default or cancellation of the loan

Answer 14

Grace Period

Question 15

also a form of loan but can be traded through PDEX

Answer 15

Bond

Question 16

PDEX

Answer 16

Philippine Dealing and Exchange (PDEX) System

Question 17

True or False: the cost of equity is generally higher than the cost of debt.

Answer 17

True

Question 18

why is the cost of equity generally higher than the cost of debt

Answer 18

since equity investors take on more risk when purchasing a company’s stock as opposed to a company’s bond. therefore, an equity investor will demand higher returns

Question 19

Factors that influence the Equilibrium interest rate (3)

Answer 19

1. Inflation
2. Risk
3. Liquidity preference

Question 20

Factor the influence EIR: rising trend in the prices of most goods and services, investors would demand higher returns to compensate for decreased purchasing power

Answer 20

Inflation

Question 21

Factor the influence EIR: Higher __ lead investors to expect a higher return on investment.

Answer 21

Risk

Question 22

Factor the influence EIR: General tendency of investors to prefer short-term securities because they are more liquid and involve relatively lower risk

Answer 22

Liquidity Preference

Question 23

The rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world

Answer 23

real rate of interest

Question 24

represents the most basic cost of money, changes with changing economic conditions, tastes, and preferences

Answer 24

real rate of interest

Question 25

the actual rate of interest charged by the supplier of funds and paid by the demander

Answer 25

nominal interest rate

Question 26

also known as actual interest rate

Answer 26

nominal interest rate

Question 27

the nominal rate differs from the real rate of interest as a result of two factors:

Answer 27

1. inflation premium | 2. risk premium

Question 28

the ____ rate embodies the real rate of interest plus the expected inflation premium

Answer 28

risk-free rate

Question 29

the relationship between the maturity and rate of return for bonds with similar levels of risk

Answer 29

term structure of interest rates

Question 30

the term structure of interest rates is depicted graphically in a:

Answer 30

yield curve

Question 31

tells analysts how rates vary between short, medium, and long-term bonds. also provides information on where interest rates and the economy are headed in the future

Answer 31

yield curve (term structure of interest rates)

Question 32

determined by the equilibrium between supplier and demanders of short-term funds

Answer 32

short-term interest rates

Question 33

determined by the equilibrium between supplier and demanders of long-term funds

Answer 33

long-term interest rate

Question 34

an upward sloping yield curve that indicates that long-term interest rates are generally higher than short-term interest rates

Answer 34

normal yield curve

Question 35

a downward sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.

Answer 35

inverted yield curve

Question 36

a yield curve that indicates that interest rates do not vary much at different maturities

Answer 36

flat yield curve

Question 37

three theories that are frequently cited to explain the general shape of the yield curve

Answer 37

1. expectations theory 2. liquidity preference theory 3. market segmentation theory

Question 38

theory that the yield curve reflects investor expectations about future interest rates

Answer 38

expectations theory

Question 39

expectations theory: an expectation of rising interest rates results in ____ sloping yield curve; an expectation of declining rates result in ____ sloping yield curve

Answer 39

upward; downward

Question 40

a theory that suggests that long term rates are generally higher than short-term rates because investors perceive short-term investments to be more liquid and less risky than long-term investments

Answer 40

Liquidity Preference Theory

Question 41

this theory is n explanation for the upward-sloping yield curve

Answer 41

liquidity preference theory

Question 42

in liquidity preference theory, Investors generally prefer to buy _____ securities, while issuers/borrowers prefer to sell _____ securities (longer time to pay for debt)

Answer 42

short-term, long-term securities

Question 43

this theory suggests that the market for loans is totally segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate

Answer 43

market segmentation theory

Question 44

in market segmentation theory, this curve indicates greater borrowing demand relative to the supply of funds in the long-term segment of the debt market relative to the short-term segment

Answer 44

upward-sloping yield curve

Question 45

to calculate the risk premium of other securities

Answer 45

subtract Treasury bond (risk-free rate) to other securities

Question 46

the possibility that the issuer will not pay the contractual interest or principal as scheduled

Answer 46

default risk

Question 47

the longer the maturity, the more the value of a security will change in response to a given change in interest rates

Answer 47

Maturity (interest rate) risk

Question 48

conditions that are often included in a debt agreement or a stock issue

Answer 48

contractual provisions

Question 49

corporate bonds: amount borrowed by the company and amount owed to the bondholder on the maturity date

Answer 49

par (face) value

Question 50

corporate bonds: time at which a bond becomes due and the principal mus be repaid

Answer 50

maturity date

Question 51

corporate bonds: percentage of a bond's par value that will be paid annually, typically in two equal semiannual payments, as interest

Answer 51

coupon rate

Question 52

long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it n the future under clearly defined terms

Answer 52

corporate bond

Question 53

two legal aspects of corporate bonds

Answer 53

standard debt provisions and restrictive covenants

Question 54

legal aspect of corporate bonds: specify certain record-keeping and general business practice that the bond issuer must follow

Answer 54

Standard Debt Provisions

Question 55

corporate bonds: normally include restrictive covenants, place operating and financial constraints on the borrower

Answer 55

Restrictive Covenants

Question 56

a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation

Answer 56

bond indenture

Question 57

most common restrictive covenants: (6)

Answer 57

require minimum liquidity level 2. prohibit sale of accounts receivable 3. impose fixed-asset restrictions 4. constrain subsequent borrowing 5. limit annual cash dividend payments

Question 58

cost of bonds to issuer: the longer the bond's maturity, the ____ he interest rate to the firm

Answer 58

maturity

Question 59

cost of bonds to issuer: the larger the size of the offering, the ___ will be the cost of the bond

Answer 59

lower

Question 60

cost of bonds to issuer: the greater the default risk of the issuing firm, the ___ the cost of the issue

Answer 60

default risk

Question 61

cost of bonds to issuer: the cost of money in the capital market is the basis for determining a bond's __________ rate

Answer 61

coupon interest rate

Question 62

the rate of interest paid by the bond issuer

Answer 62

cost of bonds to issuer

Question 63

general features of a bond issue: (3)

Answer 63

1. conversion feature 2. call feature 3. stock purchase warrants

Question 64

general features of a bond issue: allows bondholders to change each bond into a stated number of shares of common stock

Answer 64

COnversion feture

Question 65

general features of a bond issue: call feature

Answer 65

gives the issuer the opportunity to repurchase bonds prior to maturity

Question 66

general features of a bond issue: gives holders the right to buy a certain number of shares of the issuer's common stock

Answer 66

Stock purchase warrants

Question 67

when the amount by which a bond's call price exceeds its par value, it is equal to one-year coupon interest and compensates the holder for having it called prior to maturity.

Answer 67

call premium

Question 68

three most widely cited yields: (3)

Answer 68

1. current yield 2. yieldto maturity 3. yield to call

Question 69

bond yields: a measure of a bond's cash return for the year; interest payment divided by the current price

Answer 69

current yield

Question 70

bond yields: compound annual rate of return earned on a debt security purchased on a given day and held to maturity

Answer 70

Yield to maturity

Question 71

bond yields: yield of the bond if you were to buy and hold the security until call date

Answer 71

Yield to call

Question 72

___ yield: typically involves equity market, dividend income, and stock price

Answer 72

Current yield

Question 73

_____ typically involves the bond market, coupon payment, and price vs. face value

Answer 73

Yield to Maturity

Question 74

assess the riskiness of publicly traded bond issues

Answer 74

Independent rating agencies

Question 75

evaluate and attach ratings to credit instrumnts

Answer 75

Cret-rating agencies

Question 76

Types of Bonds - Unsecured: (3)

Answer 76

1. Debenture 2. Subordinated debenture 3. Income bonds

Question 77

Types of Bonds - Unsecured: bonds that only creditworthy firms can issue; claims are the same as those of any general creditor

Answer 77

Debenture

Question 78

Types of Bonds - Unsecured: claims are not paid until senior debts have been fully satisfied; claim is that of a general creditor but not as good as a senior debt claim

Answer 78

Subordinate debenture

Question 79

Types of Bonds - Unsecured: payment of interest is required only when earnings are available; claim is that of a general creditor

Answer 79

Income bonds

Question 80

Types of Bonds - Secured (3):

Answer 80

1. mortgage bonds 2. collateral trust bonds 3. equipment trust certificates

Question 81

Types of Bonds - Secured: secured by real estate or buildings; claim is on proceeds from sale of mortgaged assets

Answer 81

Mortgage bonds

Question 82

Types of Bonds - Secured: secured by stock and/or bonds; claim is on proceeds from stock and/or bond collateral

Answer 82

collateral trust bonds

Question 83

Types of Bonds - Secured: used to finance rolling stock"; claim is on proceeds from the sale of the asset

Answer 83

Equipment trust certificates

Question 84

process that links risk and return to determine the worth of an asset

Answer 84

Bond valuation

Question 85

three key inputs to the valuation process

Answer 85

1. cash flows (returns) 2. timing 3. a measure of risk, which determines the required return

Question 86

in general, the greater the risk of (or the less certain a cash flow, the _____ its value.

Answer 86

lower

Question 87

the higher the risk, the ____the required return, and the lower the risk, the _____ the required return

Answer 87

higher, lower

Question 88

the value of any asset is the _____ value of all future cash flows it is expected to provide over the relevant time period

Answer 88

present

Question 89

it is equal to the cash flows (CF) expected at the end of year n

Answer 89

Future Value

Question 90

true or false: the bond price would be the present value of cash flows, the payments the issuer is contractually obligated to make until maturity which would include the interest payments and the principal

Answer 90

true

Question 91

contract rate > market rate

Answer 91

bond sells at a premium

Question 92

contract rate = market rate

Answer 92

bond sells at par

Question 93

contract rate < market rate

Answer 93

bond sells at discount

Question 94

contract rate is sometimes called:

Answer 94

coupon rate, stated rate, and nominal rate

Question 95

increase in the basic ost of long-term funds o in in risk will ____ the required return; decreases in cost of funds or in risk will _____ the required return

Answer 95

raise, lower