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BONDS AND OTHER SOURCES OF DEBT ANSWERS TO END OF CHAPTER QUESTIONS: 1. a. Indenture - the contract between the issuing firm and the lenders in a debt obligation, specifying the nature of the debt issue, the manner in which the principal must be paid, and the restrictions (covenants) placed on the firm by the lenders. b. Trustee - the bondholders’ representative in a public debt offering. The trustee is responsible for monitoring the borrower's compliance with the terms of the indenture. c. Call feature - a provision that permits the bond issuer to retire the obligation prior to its maturity. d. Sinking fund - a method of providing for the gradual retirement of a bond issue. The sinking fund requirement can be met by depositing a certain amount of money annually in a sinking fund account. Alternatively, the firm can either purchase a portion of the debt each year in the open market or, if the debt is callable, use a lottery technique to determine which actual bonds will be called and retired each year. e. Put feature – a provision that entitles the bondholder to sell the bond back (“put” back) to the issuer before maturity at a pre-determined price. f. Conversion feature - a provision that allows the holder to exchange the bond for shares of the company's common stock at the option of the holder. g. Coupon rate - the annual rate of interest paid to bondholders. It is expressed as a percentage of par value. 2. a. Mortgage bond - a debt issue that is secured by specific physical assets of the issuing company. b. Debenture - an unsecured debt issue. The quality of the debt issue depends on the general credit-worthiness of the issuing company. c. Subordinated debenture - an unsecured debt issue that is “junior” to other types of debt. In the event of liquidation or reorganization of the company, claims of subordinated debenture holders are considered only after the claims of unsubordinated debt holders. 3. Investors would have a potential tradeoff between the 6 1/8% senior issue (which promises less return and is less risky than the subordinated issue) and the 6 3/8% subordinated issue (which promises more return and is more risky than the 6 1/8% senior issue). 4. The variables which must be known (or estimated) are the expected cash returns or cash flows during each period, the required rate of return (discount rate), and the holding period of the asset. 5. a. A bond will sell at a discount if the required rate of return is greater than the coupon rate. b. A bond will sell at par value if the required rate of return is equal to the coupon rate. c. A bond will sell at a premium if the required rate of return is less than the coupon rate. 56
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This note was uploaded on 05/01/2008 for the course FIN 3113 taught by Professor Titus-piersma during the Spring '08 term at Oklahoma State.

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