CHAPTER 6 BONDS AND THEIR VALUATION (Difficulty: E = Easy, M = Medium, and T = Tough) True-False Easy: Discounted cash flows Answer: b Diff: E 1 . The market value of any real or financial asset, including stocks, bonds, or art work, may be found by determining future cash flows and then discounting them back to the present. a. True b. False Issuing bonds Answer: b Diff: E 2 . If a firm raises capital by selling new bonds, the buyer is called the "issuing firm," and the coupon rate is generally set equal to the required rate. a. True b. False Interest rate risk Answer: b Diff: E 3 . A 20-year original maturity bond with 1 year left to maturity has more interest rate risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates.) a. True b. False Interest rate risk Answer: b Diff: E 4 . Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, be subject to much more interest rate risk if you purchased a 30-day bond than if you bought a 30-year bond. a. True b. False Bond prices and interest rates Answer: a Diff: E 5 . For bonds, price sensitivity to a given change in interest rates generally increases as years remaining to maturity increases. a. True b. False Chapter 6 - Page 1
Answer: a Diff: E 6 . Typically, debentures have higher interest rates than mortgage bonds primarily because the mortgage bonds are backed by assets while debentures are unsecured. a. True b. False Debt coupon rate Answer: a Diff: E 7 . Other things equal, a firm will have to pay a higher coupon rate on a subordinated debenture than on a second mortgage bond. a. True b. False Call provision Answer: b Diff: E 8 . A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates. a. True b. False Sinking fund Answer: a Diff: E 9 . Many bond indentures allow the company to acquire bonds for a sinking fund either by purchasing bonds in the market or by a lottery administered by the trustee for the purchase of a percentage of the issue through a call at face value. a. True b. False Zero coupon bond Answer: b Diff: E 10 . A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells) at par, therefore providing compensation to investors in the form of capital appreciation. a. True b. False Floating rate debt Answer: a Diff: E 11 . The motivation for floating rate bonds arose out of the costly experience of the early 1980s when inflation pushed interest rates to very high levels causing sharp declines in the prices of long-term bonds. a. True
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