Understanding Bonds and Their Types

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Questions and Answers

What is the original amount of the bond issue being planned by Vancouver Development Company (VDC)?

$10 million

$150 million

$50 million

$100 million (correct)

What is the annual interest rate on the bonds being issued by VDC?

10%

18%

12% (correct)

How often are the interest payments made on the bonds issued by VDC?

Monthly

Semiannually (correct)

Annually

Quarterly

What percentage of the original bond issue is retired each year by the sinking fund?

10% (C) Signup and view all the answers

If VDC chooses to call bonds at par, what is the maximum percentage of the original issue that can be called each year?

5% (C) Signup and view all the answers

What is the expected annual interest rate on the government bonds that VDC plans to buy with the sinking fund proceeds?

7% (A) Signup and view all the answers

If VDC sets up its sinking fund so that equal annual amounts are paid into a sinking fund trust, what will be the total amount accumulated in the trust at the end of 10 years?

$100 million (A) Signup and view all the answers

What factors might cause the annual sinking fund payments to be higher or lower than the initially calculated amount?

Changes in interest rates on government bonds (A), Changes in the price of VDC's bonds on the open market (B), Changes in the company's financial performance (C) Signup and view all the answers

What is the primary purpose of a sinking fund provision?

To reduce debt by regularly setting aside money. (B) Signup and view all the answers

Which type of bond has the lowest priority in the event of a company's liquidation?

Subordinated debenture (C) Signup and view all the answers

What does the yield to maturity (YTM) indicate?

The total return an investor can expect if the bond is held until maturity. (D) Signup and view all the answers

What characterizes a zero-coupon bond?

It does not make periodic interest payments. (D) Signup and view all the answers

When bond prices rise, what happens to yield?

Current yield decreases. (D) Signup and view all the answers

Which aspect is considered as price risk?

The risk of bond prices decreasing due to interest rate increases. (A) Signup and view all the answers

What is an investment-grade bond typically characterized by?

Low risk and high credit quality. (D) Signup and view all the answers

A callable bond provides the issuer with what advantage?

The option to retire the bond early if interest rates decrease. (C) Signup and view all the answers

What was the original yield to maturity (YTM) for Pennington's bonds, given that they were sold at par?

12% (D) Signup and view all the answers

What is the annual coupon payment for Pennington's bonds if the coupon rate is 12% on a $1,000 face value?

$120 (C) Signup and view all the answers

What is the current yield when the bond price is $1,182.56 and the annual coupon payment is $120?

10.15% (C) Signup and view all the answers

How is capital gains yield calculated in relation to total yield and current yield?

Total yield - Current yield (C) Signup and view all the answers

If Pennington's bond has a YTM of 14% and a current yield of 13.09%, what is the capital gains yield?

-0.91% (B) Signup and view all the answers

What is the bond price on July 1, 2011, if the inputs for the financial calculator are N=13, I/YR=7.75%, PMT=60, FV=1000?

$859.76 (C) Signup and view all the answers

What total value do you obtain when you add the coupon payment to the bond price on the next interest payment date?

$919.76 (B) Signup and view all the answers

What is the formula used to find the current yield?

Annual Coupon Payment / Price (C) Signup and view all the answers

What is the present value (PV) of the investment if the future value (FV) is $919.76 with an interest rate of 7.75%?

$875.11 (C) Signup and view all the answers

How much of the total amount of $875.11 represents accrued interest?

$20.00 (B) Signup and view all the answers

If VDC purchases bonds on the open market, what will be the sinking fund payment if the bonds are selling less than par?

$5,000,000 (D) Signup and view all the answers

What results in the decline of debt service requirements?

Reduction in the amount of bonds outstanding (C) Signup and view all the answers

What will be the total cash bond service requirement for the first year?

$21.7 million (B) Signup and view all the answers

How is interest calculated for the bonds if the interest rate is 12%?

As (0.5)(0.12)(Outstanding Bonds) (A) Signup and view all the answers

What would be the interest payment in period 2 for $95 of outstanding bonds at 12% interest?

$5.7 (A) Signup and view all the answers

What is the breakdown of the total payment of $875.11 in relation to bond's value?

$20 accrued interest, $855.11 basic value (C) Signup and view all the answers

Study Notes

Key Terms

Bond: A debt security representing a loan made by an investor to a borrower (company or government).
Treasury bond: A bond issued by a national government.
Corporate bond: A bond issued by a corporation.
Municipal bond: A bond issued by a state, local government, or municipality.
Foreign bond: A bond issued by a foreign government or corporation.
Par value: The face value of a bond, which is the amount the issuer repays at maturity.
Maturity date: The date on which the principal amount of a bond is repaid.
Original maturity: The original term of a bond.
Coupon payment: Periodic interest payments made to bondholders.
Coupon interest rate: The annual interest rate paid on a bond.
Fixed-rate bond: A bond with a fixed interest rate throughout its life.
Floating-rate bond: A bond with an interest rate that adjusts periodically based on a benchmark rate.
Zero coupon bond: A bond that does not pay periodic interest but trades at a discount to its face value.
Original issue discount (OID) bond: A bond that trades at a discount to its face value due to its zero or low coupon interest rate.
Call provision: Gives the issuer the option to repay the bond before its maturity date.
Sinking fund provision: A requirement for the issuer to periodically retire a portion of the bond issue.
Convertible bond: Bonds that can be converted into equity (stock) of the issuing company..
Warrant: A certificate granting the holder the right to purchase shares of a company's stock at a predetermined price.
Puttable bond: A bond that the holder can sell back to the issuer at a certain price before maturity.
Income bond: A bond whose interest payments are contingent on the issuer's income.
Indexed, or purchasing power, bond: A bond whose interest payments or principal are tied to an index like inflation.
Discount bond: A bond that trades below its face value.
Premium bond: A bond that trades above its face value.
Yield to maturity (YTM): The total return anticipated on a bond if held until it matures.
Yield to call (YTC): The total return anticipated on a bond if it is called before maturity.
Current yield: The annual interest income divided by the current market price of the bond.
Capital gains yield: The change in the bond's price over a period, expressed as a percentage.
Total return: Total return of the bond including the current yield and capital gains yield.
Price risk: The risk that a bond's price will decline due to changes in interest rates.
Reinvestment risk: The risk that interest payments received on a bond cannot be reinvested at the same rate.
Investment horizon: The period of time an investor plans to hold a bond.
Default risk: The risk that the issuer of a bond will be unable to make interest payments or repay the principal.
Duration: A measure of a bond's sensitivity to changes in interest rates.
Mortgage bond: A bond secured by a mortgage on real estate.
Indenture: A legal document outlining the terms of a bond issue.
Debenture: A bond that is not secured by specific assets.
Subordinated debenture: A bond that is subordinate in claim to other debt in the case of default.
Investment-grade bond: A bond rated as having a low risk of default.
Junk bond: A bond rated as having a high risk of default.

Bond Valuation

Pennington Corporation: Issued bonds on January 1, 1988, with a 12% coupon, maturing in 30 years.
Par Value: $1,000
Coupon Payments: Semiannual (June 30 and December 31).
Original YTM: 12% (since bonds were sold at par).
YTM in 1993: 10% (if interest rates had fallen)
Bond Price in 1993: $1,182.56 (calculated using a financial calculator)

Sinking Fund (Additional information)

Vancouver Development Company (VDC) plans a $100 million, 10-year, 12% bond issue with sinking fund provisions.
Sinking fund payments: 10% of the initial amount made at the end of each year, to retire bonds, these can be bought on the open market or with a call provision.
Alternative Plan: Payment of equal amounts into a sinking fund trust to buy government bonds paying 7% annual interest, and will total $100 million.
Cash requirements: Calculating annual sinking fund payments (might or may not stay constant)

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Description

This quiz covers essential terminology related to bonds, including various types like treasury bonds, corporate bonds, and municipal bonds. Test your knowledge on key concepts such as par value, maturity date, and coupon payments. Perfect for finance students and professionals alike!