Solutions_Ch_7_8 - ANSWERS TO END-OF-CHAPTER QUESTIONS:...

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7-1 Yes, the statement is true. 7-2 False. Short-term bond prices are less sensitive than long-term bond prices to interest rate changes because funds invested in short-term bonds can be reinvested at the new interest rate sooner than funds tied up in long-term bonds. 7-3 The price of the bond will fall and its YTM will rise if interest rates rise. If the bond still has a long term to maturity, its YTM will reflect long-term rates. Of course, the bond’s price will be less affected by a change in interest rates if it has been outstanding a long time and matures shortly. While this is true, it should be noted that the YTM will increase only for buyers who purchase the bond after the change in interest rates and not for buyers who purchased previous to the change. If the bond is purchased and held to maturity, the bondholder’s YTM will not change, regardless of what happens to interest rates. 7-4 If interest rates decline significantly, the values of callable bonds will not rise by as much as those of bonds without the call provision. It is likely that the bonds would be called by the issuer before maturity, so that the issuer can take advantage of the new, lower rates. 7-5 From the corporation’s viewpoint, one important factor in establishing a sinking fund is that its own bonds generally have a higher yield than do government bonds; hence, the company saves more interest by retiring its own bonds than it could earn by buying government bonds. This factor causes firms to favor the second procedure. Investors also would prefer the annual retirement procedure if they thought that interest rates were more likely to rise than to fall, but they would prefer the government bond purchase program if they thought rates were likely to fall. In addition, bondholders recognize that, under the government bond purchase scheme, each bondholder would be entitled to a given amount of cash from the liquidation of the sinking fund if the firm should go into default, whereas under the annual retirement plan, some of the holders would receive a cash benefit while others would benefit only indirectly from the fact that there would be fewer bonds outstanding. On balance, investors seem to have little reason for choosing one method over the other, while the annual retirement method is clearly more beneficial to the firm. The consequence has been a pronounced trend toward annual retirement and away from the accumulation scheme. 7-6 a. If a bond’s price increases, its YTM decreases. Answers and Solutions: 7 - 1 ANSWERS TO END-OF-CHAPTER QUESTIONS: Chapter 7
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b. If a company’s bonds are downgraded by the rating agencies, its YTM increases. c. If a change in the bankruptcy code made it more difficult for bondholders to receive payments in the event a firm declared bankruptcy, then the bond’s YTM would increase.
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This note was uploaded on 05/10/2010 for the course FMT 0438310384 taught by Professor Hung during the Spring '10 term at Aarhus Universitet, Aarhus.

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Solutions_Ch_7_8 - ANSWERS TO END-OF-CHAPTER QUESTIONS:...

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