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Business Administration - Financial Planning RFC230 Lecture Notes - Lecture 6: Callable Bond, Fixed Income, Reinvestment Risk

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greenmuskrat329
6 Mar 2017
School
Seneca College
Department
Business Administration - Financial Planning
Course
Business Administration - Financial Planning RFC230
Professor
marysavona

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Document Summary

5 and 6 5 fixed income selection and evaluation. Wide variety of available bond features, including inflation protection, callable, extendible, step-up, and floating-rate among the most common. Some features are to the benefit of the issuer and present risks to the investor: investor should be compensated with a higher yield; advisors should be familiar with valuation methods to ensure fair pricing. Callable bonds can be redeemed by the issuer prior to the maturity. An issuer will likely redeem the bond when interest rates have declined, and may replace the existing bond with a lower coupon bond. If this occurs, the bond investor will only be able to reinvest his principal at lower yields. Callable bonds then increase reinvestment risk and yield is typically quoted as yield-to-call vs. yield-to-maturity. Some features are to the benefit of the investor: benefits usually come at the cost of lower yields than comparable straight bonds.

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Related Questions

The (-Select- A. discount B. premium C. par) value of a bond is its stated face value or maturity value, and its coupon interest rate is the stated annual interest rate on the bond. The maturity date is the date on which the par value must be repaid. A (-Select- A. call B. redemption C. sinking) provision gives the issuer the right to redeem the bonds under specified terms prior to their normal maturity date, although not all bonds have this provision. Some bonds have (-Select- A. redemption fund B. sinking fund C. call fund) provisions which require the issuer to systematically retire a portion of the bond issue each year. Because sinking fund provisions facilitate their orderly retirement, bonds with these provisions are regarded as being (-Select-A. riskier B. safer C. equivalent) so they will have (-Select- A. lower B. equivalent C. higher) coupon rates than similar bonds without these provisions.

Bonds can be (-Select- A. floating B. zero C. fixed) -rate bonds with a constant coupon rate over the life of the bond, or they can be (-Select- A. floating B. zero C. fixed) -rate bonds with a coupon rate that varies over time depending on the level of interest rates. (-Select- A. Annual coupon B. Zero coupon C. Fixed coupon) bonds pay no annual interest but are sold at a (-Select- A. premium above B. price at C. discount below) par, thus compensating investors in the form of capital appreciation. An original issue discount (OID) bond is any bond originally offered at a price (-Select- A. above its B. below its C. equal to) par value.

(-Select- A. Convertible B. Perpetual C. Putable) bonds are exchangeable at the option of the holder for the issuing firm's common stock. Bonds can be issued with warrants giving the holder the option to purchase the firm's stock for a stated price, thereby providing a capital gain if the stock's price rises. (-Select- A. Income B. Convertible C. Putable) bonds contain a provision that allows holders to sell them back to the company prior to maturity at a prearranged price. (-Select- A. Income B. Default C. Preferred) bonds pay interest only if the firm has earnings, while an indexed (purchasing power) bond bases interest payments on an inflation index to protect the holder from inflation.

Mortgage bonds are backed by (-Select- A. current assets B. fixed assets C. marketable securities) . First mortgage bonds are senior in priority to claims of second mortgage bonds. Debentures are long-term bonds that are not secured by a mortgage. Subordinated debentures are bonds having claims on assets only after senior debt has been paid in full in the event of liquidation. (-Select- A. Secured-debenture B. Investment-grade) bonds are rated triple B or higher, and many banks and other institutional investors are legally limited to only holding these bonds. In contrast, junk bonds are high-risk, high-yield bonds.

Multiple Choice Quiz
PLS EXPLAIN ALL YOUR ANSWERS
1
If a bond's rating improves:
A) It should cause the bond's price and yield to increase, allother factors constant.
B) It should cause the bond's price and yield to decrease, allother factors constant.
C) It should cause the bond's price to increase and its yield todecrease, all other factors constant.
D) None of the above.



2
An investor earning 6% from a tax-exempt bond, who is in a 25% taxbracket, holding risk constant:
A) Would be indifferent to a taxable bond with a 7.5% yield.
B) Would be indifferent to a taxable bond with a 8.0% yield.
C) Would be indifferent to a taxable bond with a 4.5% yield.
D) None of the above.



3
When the yield curve is downward sloping:
A) People are expecting an economic slowdown.
B) Short term yields are lower than long term yields.
C) This is impossible, since the yield curve always slopesupward.
D) People could be expecting a loosening in monetary policy.



4
Assume the Expectation Hypothesis regarding the term structure ofinterest rates. If the current one-year interest rate is 4% and thecurrent two-year interest rate is 6%, then:
A) Investors are expecting the future one-year rate to be 4%.
B) Investors are expecting the future one-year rate to be 8%.
C) Investors are expecting the future one-year rate to be 6%.
D) None of the above.



5
Which of the following statements is(are) true?
A) Conforming mortgages are mortgages for which the borrowers donot meet standards of creditworthiness.
B) Subprime mortgages are often made to individuals with low creditscores or income levels that are relatively low when compared tothe price of the home.
C) Subprime mortgages are never used in mortgage backed securitiesbecause of their riskiness.
D) All of the above.



6
Assume an investor has a choice of 3 consecutive one-year bonds orone 3-year bond. Assuming the Expectations Hypothesis of the termstructure of interest rates:
A) The average interest rate of the three consecutive one-yearbonds should be less than the 3-year bond to reflect the riskpremium.
B) The interest rate of the 3-year bond should equal the averageinterest rate of the 3 one-year bonds.
C) The three consecutive one-year bonds must have the same interestrate.
D) The current one-year interest rate must equal the current 3-yearinterest rate.



7
We would expect the risk spread between Baa bonds and U.S. Treasurysecurities of the same maturities to:
A) Widen during periods of economic recession.
B) To remain relatively constant over the business cycle.
C) To decrease during economic slowdowns.
D) To increase during economic growth periods.



8
Increased borrowing by the U.S. Treasury to finance growing budgetdeficits will:
A) Result in U.S. Treasury yields being higher than high gradecorporate bonds.
B) Result in the price of U.S. Treasury bonds rising.
C) Cause the yield on U.S. Treasury bonds to increase, but still belower than corporate bonds.
D) Result in lower yields on corporate bonds.



9
Imagine a scandal that finds the officers of bond rating agencieshave been taking bribes to inflate the rating of specific bonds.This should:
A) Have no impact on the bond market since bond markets are highlyefficient.
B) Decrease the demand for all bonds.
C) Increase the demand for U.S. Treasury securities and decreasethe demand for corporate bonds.
D) Decrease the risk spread.



10
A proposed increase in the federal income tax rates may actually beviewed favorably by many mayors of cities because:
A) It will allow them to also raise their tax rates.
B) It will cause the demand for Municipal bonds to increase andtheir yields to increase.
C) People will pay less attention to local taxes.
D) It will cause the price of municipal bonds to increase and theiryields to decrease.



11
Bonds rated as "highly speculative":
A) Are rated so because they guarantee high returns for thebuyer.
B) Are commonly referred to as junk bonds.
C) Are ranked just below investment grade by Standard &Poor's.
D) Are rated so because they do not have any default risk.



12
Ratings problems contributed to the financial crisis of 2007-2009because:
A) Ratings agencies sharply downgraded the ratings of MBS ashousing prices declined, reinforcing the decline in the prices ofMBS.
B) MBS issuers consulted ratings agencies to structure MBS to getthe highest ratings, causing a conflict of interest.
C) Ratings agencies were compensated by the issuers of the MBS,causing the incentive for favorable ratings.
D) All of the above.



13
An investor in a 30% marginal tax bracket, earning $10 in interestannually for a $100 U.S. Treasury bond:
A) Earns a 10% after-tax return because interest on U.S. Treasurybonds is tax exempt at the federal level.
B) Earns a 3% return after-tax.
C) Would be indifferent between this bond and a municipal bondoffering $7 annually per $100 of face value, assuming the samedefault risk.
D) Earns a 1% return after-tax.



14
Commercial paper refers to:
A) The financial publications read by the CEO's of publiccorporations.
B) Any debt security with a maturity exceeding one year.
C) Short-term collateralized securities issued only bycorporations.
D) Unsecured short-term debt issued by corporations andgovernments.



15
The addition of the Liquidity Premium Theory to the ExpectationsHypothesis allows us to explain why:
A) Yield curves usually slope upward.
B) Interest rates on bonds of different maturities movetogether.
C) Long-term interest rates are less volatile than short terminterest rates.
D) Yield curves are flat.


1. Which of the following is true?
The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.
Question 2.2. Which of the following is false?
For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.
Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false? (Points : 3.5)
The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.
Question 4.4. Which of the following is true? (
As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.
Question 5.5. Which of the following is false?
If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.
Question 6.6. Which of the following is not true? (Points : 3.5)
According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a company’s expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.
Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call?
6.87%.
7.37%.
11.05%.
8.32%.
Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)
It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.
Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta?
1.56.
1.82.
2.00.
1.94
Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is
fairly priced.
undervalued.
overvalued.
Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000.
14.58%.
13.92%.
16.34%.
12.17%.
Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV? (Points : 3.5)
$259.57.
$221.86.
$195.23.
$257.35.
Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR?
12.58%.
10.82%.
11.76%.
9.64%.
Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)
5.40 years.
10 years.
4.58 years.
6.12 years.
Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR?
13.97%.
12.04%.
14.93%.
9.15%.
Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?
1.47 years.
1.24 years.
1.62 years.
1.15 years.
1. Which of the following is true?
The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.
Question 2.2. Which of the following is false?
For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.
Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false?
The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.
Question 4.4. Which of the following is true? (Points : 3.5)
As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.
Question 5.5. Which of the following is false? (Points : 3.5)
If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.
Question 6.6. Which of the following is not true? (Points : 3.5)
According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a company’s expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.
Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call? (Points : 3.5)
6.87%.
7.37%.
11.05%.
8.32%.
Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)
It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.
Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta? (Points : 3.5)
1.56.
1.82.
2.00.
1.94
Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is (
fairly priced.
undervalued.
overvalued.
Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000. (Points : 3.5)
14.58%.
13.92%.
16.34%.
12.17%.
Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV?
$259.57.
$221.86.
$195.23.
$257.35.
Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR? (
12.58%.
10.82%.
11.76%.
9.64%.
Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)
5.40 years.
10 years.
4.58 years.
6.12 years.
Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR? (
13.97%.
12.04%.
14.93%.
9.15%.
Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?
1.47 years.
1.24 years.
1.62 years.
1.15 years.