CH25 - CHAPTER 25 The Many Different Kinds of Debt Answers...

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CHAPTER 25 The Many Different Kinds of Debt Answers to Practice Questions 1. If the bond is issued at face value and investors demand a yield of 9.5%, then, immediately after the issue, the price will be $1,000. As time passes, the price will gradually rise to reflect accrued interest. For example, just before the first (semi-annual) coupon payment, the price will be $1,047.50, and then, upon payment of the coupon ($47.50), the price will drop to $1,000. This pattern will be repeated throughout the life of the bond as long as investors continue to demand a return of 9.5%. 2. Answers here will vary, depending on the company chosen. Some key areas that should be examined are: coupon rate, maturity, security, sinking fund provision, and call provision. 3. Floating-rate bonds provide bondholders with protection against inflation and rising interest rates, but this protection is not complete. In practice, the extent of the protection depends on the frequency of the rate adjustments and the benchmark rate. (Not only can the yield curve shift, but yield spreads can shift as well.) Similarly, puttable bonds provide the bondholders with protection against an increase in default risk, but this protection is not absolute. If the company’s problems suddenly become public knowledge, the value of the company may fall so quickly that bondholders might still suffer losses even if they put their bonds immediately. 4. First mortgage bondholders will receive the $200 million proceeds from the sale of the fixed assets. The remaining $50 million of mortgage bonds then rank alongside the unsecured senior debentures. The remaining $100 million in assets will be divided between the mortgage bondholders and the senior debenture holders. Thus, the mortgage bondholders are paid in full, the senior debenture holders receive $50 million and the subordinated debenture holders receive nothing. 234
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5. If the assets are sold and distributed according to strict precedence, the following distribution will result. In Subsidiary A, the $320 million of debentures will be paid off and ($500 million - $320 million) = $180 million will be remitted to the parent. In Subsidiary B, the $180 million of senior debentures will be paid off and ($220 million - $180 million) = $40 million of the $60 million subordinated debentures will be paid. In the holding company, the real estate will be sold and ($180 million + $80 million) = $260 million will be paid in partial satisfaction of the $400 million senior collateral trust bonds. 6. a. Typically, a variable-rate mortgage has a lower interest rate than a comparable fixed-rate mortgage. Thus, you can buy a bigger house for the same mortgage payment if you use a variable-rate mortgage. The second consideration is risk. With a variable-rate mortgage, the borrower assumes the interest rate risk (although in practice this is mitigated somewhat by the use of caps), whereas, with a fixed-rate mortgage, the
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This note was uploaded on 10/19/2009 for the course FINANCE finance mb taught by Professor Myers during the Spring '09 term at NUCES - Lahore.

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CH25 - CHAPTER 25 The Many Different Kinds of Debt Answers...

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