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1. Under normal conditions, which of the following would be most likely to increase the coupon rate required for a bond to be issued at par? a. Adding additional restrictive covenants that limit management's actions. b. Adding a call provision. c. The rating agencies change the bond's rating from Baa to Aaa. d. Making the bond a first mortgage bond rather than a debenture. e. Adding a sinking fund. Answer: b 2. Which of the following statements is CORRECT? a. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued. b. Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature. c. A sinking fund provision makes a bond more risky to investors at the time of issuance. d. Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time. e. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price. Answer: a 3. Amram Inc. can issue a 20-year bond with a 6% annual coupon at par. This bond is not convertible, not callable, and has no sinking fund. Alternatively, Amram could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Amram would have to pay on the second bond, the convertible, callable bond with the sinking fund, to have it sell initially at par? a. The coupon rate should be exactly equal to 6%. b. The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the real world the convertible feature would probably cause the coupon rate to be less than 6%. c. The rate should be slightly greater than 6%. d. The rate should be over 7%. e. The rate should be over 8%. Answer: b The second bond's convertible feature and sinking fund would tend to lower its required rate of return, but the call feature would raise its rate. Given these opposing forces, the second bond's required coupon rate could be above or below that of the first bond. However, the convertible feature generally dominates in the real world, so convertibles' coupon rates are generally less than comparable non- convertible issues' rates. 4. Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non- callable, but this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their required rate of return?
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