Andrew Jacobson Financial

Questions 1

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4-1 Define each of the following terms:

a. Bond; Treasury bond; corporate bond; municipal bond; foreign bond b. Par value; maturity date; coupon payment; coupon interest rate c. Floating rate bond; zero coupon bond; original issue discount bond (OID)

d. Call provision; redeemable bond; sinking fund e. Convertible bond; warrant; income bond; indexed, or purchasing power, bond f. Premium bond; discount bond g. Current yield (on a bond); yield to maturity (YTM); yield to call (YTC)

h. Reinvestment risk; interest rate risk; default risk i. Indentures; mortgage bond; debenture; subordinated debenture j. Development bond; municipal bond insurance; junk bond; investment-grade bond

4-2 "The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices." Is this statement true or false? Explain.

4-3 The rate of return you would get if you bought a bond and held it to its maturity date is called the bond's yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond's price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond's price?

4-4 If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

4-5 A sinking fund can be set up in one of two ways:

(1) The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity.

(2) The trustee uses the annual payments to retire a portion of the issue each year, either calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper.

Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders.

Self-Test Problems (Solutions Appear in Appendix A)

ST-1 The Pennington Corporation issued a new series of bonds on January 1, 1979. The bonds were BOND VALUATION Sold at par ($1,000), have a 12 percent coupon, and mature in 30 years, on December 31, 2008.

Coupon payments are made semiannually (on June 30 and December 31).

a. What was the YTM of Pennington's bonds on January 1, 1979?

b. What was the price of the bond on January 1, 1984, 5 years later, assuming that the level of interest rates had fallen to 10 percent?

c. Find the current yield and capital gains yield on the bond on January 1, 1984, given the price as determined in part b.

d. On July 1, 2002, Pennington's bonds sold for $916.42. What was the YTM at that date?

e. What were the current yield and capital gains yield on July 1, 2002?

f. Now, assume that you purchased an outstanding Pennington bond on March 1, 2002, when the going rate of interest was 15.5 percent. How large a check must you have written to complete the transaction? This is a hard question! (Hint: P"VTFA7.75%,13 = 8.0136 and PVIF7.75%,13 = 0.3789.)

ST-2 The Vancouver Development Company has just sold a $100 million, 10-year, 12 percent bond SINKING FUND issue. A sinking fund will retire the issue over its life. Sinking fund payments are of equal amounts and will be made semiannually, and the proceeds will be used to retire bonds as the payments are made. Bonds can be called at par for sinking fund purposes, or the funds paid into the sinking fund can be used to buy bonds in the open market.

a. How large must each semiannual sinking fund payment be?

b. What will happen, under the conditions of the problem thus far, to the company's debt service requirements per year for this issue over time?

c. Now suppose Vancouver Development set up its sinking fund so that equal annual amounts, payable at the end of each year, are paid into a sinking fund trust held by a bank, with the proceeds being used to buy government bonds that pay 9 percent interest. The payments, plus accumulated interest, must total $100 million at the end of 10 years, and the proceeds will be used to retire the bonds at that time. How large must the annual sinking fund payment be now?

d. What are the annual cash requirements for covering bond service costs under the trusteeship arrangement described in part c? (Note: Interest must be paid on Vancouver's outstanding bonds but not on bonds that have been retired.)

e. What would have to happen to interest rates to cause the company to buy bonds on the open market rather than call them under the original sinking fund plan?

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