Finance Chapter 7: Interest Rates and Bonds

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Questions and Answers

What is the nature of creditors in a corporation's structure?

They have voting rights during shareholder meetings.

They can vote on the board of directors.

They do not have voting rights. (correct)

They have influence in dividend declarations.

What happens when dividends are not declared by a firm?

Shareholders receive interest on the owed amount.

Shareholders have no legal recourse. (correct)

Shareholders can sue the firm.

Shareholders can demand immediate payment.

What is the primary cash flow structure of a typical bond?

No interest payments and only variable principal repayment

Interest payments only at maturity

Regular interest payments throughout the term followed by a principal repayment (correct)

Lump sum payment at issuance with no interest

Which of the following statements is true regarding equity firms?

An all-equity firm cannot go bankrupt. Signup and view all the answers

How is the coupon rate of a bond determined?

It is the annual interest payment divided by the bond's face value Signup and view all the answers

What distinguishes a debenture from a bond?

Debentures are unsecured and generally mature in ten years or more. Signup and view all the answers

What happens to the present value of a bond when market interest rates increase?

The present value decreases Signup and view all the answers

What is the maturity period for short-term debt?

Less than one year. Signup and view all the answers

Which statement accurately describes dividends?

Dividends are not liabilities until declared. Signup and view all the answers

Which of the following accurately describes 'Yield to Maturity' (YTM)?

It is the rate implied by the current bond price considering all future cash flows Signup and view all the answers

What is a distinguishing feature of a public debt issue?

It is sold to the general public. Signup and view all the answers

What term refers to the principal repayment date of a bond?

Maturity date Signup and view all the answers

What is the implication of excess debt for a firm?

Excess debt can cause financial distress and bankruptcy. Signup and view all the answers

What is the effect of a bond’s time to maturity on its sensitivity to interest rate changes?

Longer maturity bonds are more sensitive to interest rate changes Signup and view all the answers

Which factor is NOT essential in estimating a bond's current market value?

Stock price of the issuing corporation Signup and view all the answers

Which bond feature allows investors to assess the value of a bond over time?

The relationship between coupon payments and interest rates Signup and view all the answers

What is the primary difference between real rates and nominal rates?

Real rates are adjusted for inflation, whereas nominal rates are not. Signup and view all the answers

According to the Fisher Effect, which equation correctly describes the relationship among nominal rate, real rate, and inflation rate?

1 + R = (1 + r) (1 + h) Signup and view all the answers

Which component is NOT part of the determinants of bond yields?

Liquidity premium Signup and view all the answers

What does an upward-sloping yield curve typically indicate about future interest rates?

Interest rates are expected to increase in the future. Signup and view all the answers

Which premium compensates bondholders for the possibility that the bond's interest or principal might not be paid?

Default risk premium Signup and view all the answers

What does the term 'subordinated debt' signify in the context of bankruptcy?

It suggests that this debt must be paid after other creditors. Signup and view all the answers

In what form are interest payments made directly to the owner of record?

Registered form Signup and view all the answers

What arrangement typically allows a corporation to make early repayments on its bonds?

Sinking fund Signup and view all the answers

What is the purpose of the call provision in a bond agreement?

To grant the bond issuer the right to redeem the bond early. Signup and view all the answers

What is meant by 'call protected bond'?

A bond that cannot be redeemed by the issuer for a specific duration. Signup and view all the answers

How does collateral relate to debt agreements?

It is any asset pledged for the payment of a debt. Signup and view all the answers

Which provision allows the bond issuer to sell bonds at a higher price at a later time?

Call premium Signup and view all the answers

What is a sinking fund primarily used for?

To handle early redemption of bonds. Signup and view all the answers

What does the term 'mortgage securities' refer to?

Securities secured by a mortgage on real property. Signup and view all the answers

What is typically included in the indenture of a bond?

A description of property used as security Signup and view all the answers

What is the primary purpose of protective covenants in a bond indenture agreement?

To limit the firm's operational freedom while the bond is outstanding Signup and view all the answers

Which bond rating indicates the highest likelihood of default?

B Signup and view all the answers

What distinguishes municipal bonds from other types of bonds?

Their interest payments are exempt from federal income tax Signup and view all the answers

Which of the following describes Treasury securities?

They include T-bills, T-notes, and T-bonds with varying maturities Signup and view all the answers

At what bond yield would an investor be indifferent between a taxable bond yielding 8% and a municipal bond yielding 6% given a 40% tax rate?

4.0% Signup and view all the answers

What does a bond rating of BBB (S&P) signify?

It is investment-grade with moderate risk Signup and view all the answers

Why are Treasury securities unique compared to other bonds?

They possess no default risk Signup and view all the answers

What is a typical advantage of municipal bonds for high-income investors?

Exemption from federal taxes on interest income Signup and view all the answers

What action is prohibited by protective covenants for a firm that has issued bonds?

Merger with another company Signup and view all the answers

Which bond type is typically categorized as high-yield or junk bonds?

Bonds rated below BBB (S&P) Signup and view all the answers

Study Notes

Interest Rates and Bond Valuation

Bonds Overview*
Bonds are long-term debt securities issued by governments and corporations.
Typically structured as interest-only loans, where interest is paid periodically and principal is returned at maturity.
Commonly referred to as level-coupon bonds.
Key Features of Bonds*
Coupon: Stated interest payment made on a bond; for example, 120annuallyona120 annually on a 120annuallyona1,000 bond at 12%.
Coupon Rate: Annual coupon divided by face value; e.g., 12% in the above example.
Face Value: Principal amount repaid at maturity, often $1,000.
Maturity Date: Final payment date of principal plus last coupon.
Time to Maturity: Years remaining until the face value is paid.
Bond Values and Yields*
Bond cash flows remain constant, but market interest rate changes affect the present value of bonds.
Inverse relationship exists: as interest rates increase, bond prices decrease, and vice versa.
Bond value equals the present value of future coupon payments plus the present value of the principal, discounted at the yield to maturity (YTM).

Long-Term Debt: Basics

Maturity of long-term debt is over one year; short-term is less than one year.
Categorized as notes (less than ten years), debentures (unsecured, ten years or more), or bonds (secured).
Bonds may be issued publicly or privately, with terms negotiated in private placements.
Indenture*
A legal agreement detailing bond terms between borrower and creditors.
Includes terms such as bond amount, repayment, security description, and protective covenants.
Bond Payment Forms*
Registered form: Payments made to registered owners.
Bearer form: Payments made to whoever holds the bond with coupons to redeem.
Collateral and Seniority*
Collateral includes any asset pledged for debt payment.
Mortgage securities are secured by real property.
Seniority relates to priority in bankruptcy, with subordinated debt being paid after other creditors.

Repayments

Can occur at maturity or early, often facilitated by a sinking fund.
Sinking Fund: Managed account for early bond redemption, requiring annual payments.
Call Provision: Right for issuer to repurchase bond early at predetermined price.
Call Premium: Difference between call price and par value.
Deferred Call Provision: Restricts early redemption for a specified period.

Protective Covenants

Limitations in bond agreements to protect creditors:
- Restrictions on dividend payments.
- Prohibition of additional long-term debt issuance.
- Bans on mergers during bond term.

Bond Ratings

Companies often pay for credit ratings from agencies like Moody's and S&P.
Ratings indicate the likelihood of default, with AAA/Aaa as highest ratings signifying low default risk.
Bonds rated BBB (S&P) or Baa (Moody's) are deemed investment grade; lower-rated bonds are known as junk bonds.

Government Bonds

Treasury Securities: Issued by the federal government; include T-bills (maturity < 1 year), T-notes (1-10 years), T-bonds (> 10 years).
Treasury securities carry no default risk and are exempt from state income taxes but taxable federally.
Municipal Securities: Issued by state/local governments; coupon payments are usually federal tax-exempt, attractive to high-income investors.

Inflation and Interest Rates

Real vs. Nominal Rates*
Real rates adjust for inflation; indicate actual purchasing power changes.
Nominal rates are pre-inflation adjustment rates.
The Fisher Effect*
Describes the relationship: 1 + R = (1 + r) (1 + h), where R is nominal rate, r is real rate, and h is inflation rate.

Determinants of Bond Yields

Term Structure of Interest Rates*
Represents the relationship between nominal interest rates and time to maturity for default-free securities, highlighting pure time value of money.
Comprises components: real return, inflation premium, and interest rate risk premium.
Yield Curve*
Graphical representation of interest rates across different maturities.
Upward-sloping curve typically indicates higher yields for longer maturities, reflecting inflation and interest rate risk premiums.
Risk Premiums*
Default risk premium compensates for potential non-payment of interest or principal.
Taxability premium accounts for added yields required on corporate bonds compared to municipal bonds.

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Description

This quiz covers Chapter 7 of the finance course, focusing on interest rates and bond valuation. It provides insights into the nature of bonds, how they function as debt securities, and the principles of valuing bonds. Perfect for students looking to enhance their understanding of financial instruments.