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Unformatted text preview: CHAPTER 7 Bonds Valuation Homework Solutions ANSWERS TO END-OF-CHAPTER QUESTIONS 7-1. Book value is the asset's historical value and is represented on the balance sheet as cost minus accumulated depreciation. Liquidation value is the dollar sum that could be realized if the assets were sold individually and not as part of a going concern. Market value is the observed value for an asset in the marketplace where buyers and sellers negotiate a mutually acceptable price. Intrinsic value is the present value of the asset's expected future cash flows discounted at an appropriate discount rate. 7-2. The value of a security is equal to the present value of cash flows to be received by the investor. Hence, the terms value and present value are synonymous. 7-3. The first two factors affecting asset value (the asset characteristics) are the asset's expected cash flows and the riskiness of these cash flows. The third consideration is the investor's required rate of return. The required rate of return reflects the investor's risk-return preference. 7-4. The relationship is inverse. As the required rate of return increases, the value of the security decreases, and a decrease in the required rate of return results in a price increase. 7-5. (a) The par value is the amount stated on the face of the bond. This value does not change and, therefore, is completely independent of the market value. However, the market value may change with changing economic conditions and changes within the firm. (b) The coupon interest rate is the rate of interest that is contractually specified in the bond indenture. As such, this rate is constant throughout the life of the bond. The coupon interest rate indicates to the investor the amount of interest to be received in each payment period. On the other hand, the investor's required rate of return is equivalent to the bonds current yield to maturity, which changes with the changing bond's market price. This rate may be altered as economic conditions change and/or the investor's attitude toward the risk-return trade-off is altered. 7-6. In the case of insolvency, claims of debt holders in general, including bonds, are honored before those of both common stock and preferred stock. However, different 173 types of debt may also have a hierarchy among themselves as to the order of their claim on assets. Bonds also have a claim on income that comes ahead of common and preferred stock. If interest on bonds is not paid, the bond trustees can classify the firm insolvent and force it into bankruptcy. Thus, the bondholder's claim on income is more likely to be honored than that of common and preferred stockholders, whose dividends are paid at the discretion of the firm's management....
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