Deck 18: Debt Instruments

Question 1

Use the following statements to answer this question:
I.Tax deductibility of dividends makes equity very desirable.
II.An instrument can be classified as debt even if it is not so in the Income Tax Act.

A)I and II are correct.
B)I and II are incorrect.
C)I is incorrect and II is correct.
D)I is correct and II is incorrect.

Answer 1

I and II are incorrect.

Question 2

Toronto Skaters has issued $100 million in bonds paying 6% interest per year.The firm has a tax rate of 45%.The firm's annual interest payments are ______ and the after-tax cost of the debt is ______ per year.

A)$6 million, $6 million
B)$6 million, $2.7 million
C)$6 million, $3.3 million
D)$3.3 million, $2.7 million

Answer 2

$6 million, $3.3 million

Question 3

Saskatchewan Wheat Fields Inc.is planning to issue $100 million of commercial paper with 30 days to maturity.There is a 3% probability that the firm will default on the issue and the investor will receive $40 million (or 40 cents on the dollar).The investor's required rate of return is 5%.If the firm wishes to issue the commercial paper at par, the promised yield must be:

A)2.29%
B)7.01%
C)27.42%
D)42.27%

Answer 3

27.42%

Question 4

A Government of Canada T-bill with a face value of $1,000 and 45 days to maturity is trading for $985.22.The 45-day interest rate is ______ and the annual rate is ______.

A)1.5%, 12.17%
B)12.17%, 1.5%
C)1.5%, 12.84%
D)12.84%, 1.5%

Question 5

The Canada Revenue Agency uses which of the following tests to make sure that the interest on debt is tax deductible?

A)Interest is compensation for the use or retention of money owed to another.
B)Interest must be referable to a principal sum.
C)Interest accrues from day to day.
D)All of the above

Question 6

Generally, any debt instrument with a maturity of less than one year is called a ______, from one to seven years is called a ______, and more than seven years is called a ______.

A)bond, bill, note
B)bill, bond, note
C)note, bill, bond
D)bill, note, bond

Question 7

T-bill yields are quoted on a(n)______ basis.

A)compound interest
B)after-tax
C)discount
D)none of the above

Question 8

The promised yield on bankers' acceptances is typically ______ than the promised yield on the commercial paper of similar firms because ______.

A)higher; banks charge a fee to accept or guarantee the debt
B)lower; banks charge a fee to accept or guarantee the debt
C)higher; the banks that guarantee the debt are more creditworthy than the issuing firm
D)lower; the banks that guarantee the debt are more creditworthy than the issuing firm

Question 9

Which of the following has the characteristics of a fixed contractual commitment?

A)Long-term debt
B)Common share dividends
C)Preferred share
D)Retained earnings

Question 10

Which of the following represents tax-deductible expenses?
I.Rental on office building
II.Interest expense
III.Preferred stock dividends
IV.Common stock dividends

A)I and II
B)I, II, and III
C)III only
D)III and IV

Question 11

Laurentide Ski Resort has to make a choice between two different debt issues.Issue 1 has an interest rate of 5% and the interest is tax deductible.Issue 2 has an interest rate of 4% however the interest is not tax deductible.If the firm has a tax rate of 40%, which issue is preferred and why?

A)Issue 2 because the interest rate of 4% is less than the 5% of issue 1.
B)Issue 1 because the after-tax cost is 3% while the after-tax cost of issue 2 is 4%
C)Issue 1 because the after-tax cost is 2% while the after-tax cost of issue 2 is 4%
D)Issue 2 because the after-tax cost is 1.6% while the after-tax cost of Issue 1 is 2%

Question 12

Bond rating services:

A)evaluate credit or default risk.
B)can affect bond prices by the ratings they give.
C)classify Government of Canada bonds as nearly default risk free.
D)all of the above

Question 13

The issuer of bankers' acceptances is paying a promised yield of 5%.What would be the promised yield on securities of the bank guaranteeing this issue?

A)Equivalent or less than 5%
B)Higher than 5%
C)Depends on the bank's liquidity
D)Cannot be determined

Question 14

Saskatchewan Wheat Fields Inc.is planning to issue $100 million of commercial paper with 30 days to maturity.There is a 1% probability that the firm will default on the issue and the investor will receive zero.The investor's required rate of return is 5%.If the firm wishes to issue the commercial paper at par, the promised yield must be:

A)5%
B)8.25%
C)17.17%
D)42.27%

Question 15

Montreal Snowmobiles has issued bonds at par that are paying 10% interest per year.The firm has a tax rate of 40%.What is the firm after-tax cost of debt?

A)10%
B)6%
C)14%
D)7%

Question 16

Which of the following is characterized as an unsecured money market instrument?

A)Treasury bill
B)Debentures
C)Commercial paper
D)All of the above
E)a and c

Question 17

Laurentide Resorts is issuing commercial paper with 60 days to maturity.In case of default, the investor will lose the total amount.The quoted rate for the issue is 7%, and an equivalent government-backed security's rate is 6%.What is the probability of default?

A)0%
B)0.93%
C)1%
D)99.06%

Question 18

Saskatchewan Wheat Fields Inc.is planning to issue $100 million of commercial paper with 30 days to maturity.The quoted rate for the issue is 8%.There is a 3% probability that the firm will default on the issue and the investor will receive zero.If the investor's required rate of return is 5%, then the value of the issue is:

A)$100 million
B)$99.77 million
C)$99.59 million
D)$97.24 million

Question 19

Laurentide Resorts is issuing commercial paper with 60 days to maturity.In case of default, the investor will receive 40 cents on the dollar.The quoted rate for the issue is 7%, and an equivalent government-backed security's rate is 6%.What is the probability of default?

A)98.51%
B)0.94%
C)1.0%
D)1.49%

Question 20

A treasury bill (T-bill)is a ______ issued by ______.

A)short-term promissory note, high quality Canadian firms
B)bond, high quality Canadian firms
C)short-term promissory note, a government treasury department
D)bond, the government of Canada

Question 21

Which one of the following does not explain why banks enjoy lower asymmetry of information?

A)The bank has access to the firm's financial activity.
B)The company relies on the bank for financing and other hedging activities.
C)The company is required by law to give the bank access to privileged information.
D)The company provides information to negotiate banking products.

Question 22

Short-term debt securities that are unsecured obligations issued by corporations are called:

A)Treasury bills.
B)Debentures.
C)Commercial paper.
D)All of the above.

Question 23

The Winnipeg Curling Company currently has one issue of debt outstanding.Winnipeg Curling has decided to borrow more money by issuing new debt with a higher priority in the event of bankruptcy.This could result in a violation of which type of covenant on the original debt?

A)Negative pledge
B)Cross-default clause
C)The new issue will not violate any covenant as there are never covenants when a firm has only one issue of debt
D)This type of transaction is illegal

Question 24

When specific assets such as land, plant, or equipment are pledged as collateral, what is the term for the debt issue?

A)Debenture
B)Mortgage bond
C)Bond
D)Unsecured debt

Question 25

In general, a line of credit has a ______ maturity while a term loan has a ______ maturity.

A)fixed; floating
B)floating; fixed
C)fixed; fixed
D)floating; floating

Question 26

Junk bonds are:

A)speculative bonds with ratings below investment grade
B)subordinated debentures
C)a nickname for bonds traded in the Hong Kong market
D)corporate bonds of bankrupt companies

Question 27

Rank the following in order of priority in the event of bankruptcy:
I.Subordinated, secured debt
II.Subordinated, unsecured debt
III.Unsubordinated, secured debt
IV.Unsubordinated, unsecured debt

A)III, I, IV, II
B)IV, I, III, II
C)III, IV, I, II
D)IV, II, III, I

Question 28

Evaluate the following statement:
Private debt financing is generally cheaper than public financing.

Question 29

In general a "floating rate" on a debt issue refers to:
I.Variable payment times for the interest payments
II.Variable interest payments
III.Yield on the debt equals the average dividend yield on the Toronto Stock Exchange

A)I and II
B)II
C)II and III
D)I and III

Question 30

Investment-grade debt rating refers to which of the following?

A)The issuer is less likely to meet debt payment obligations.
B)The issuer is more likely to increase dividend payments.
C)The issuer is likely to meet debt payment obligations.
D)None of the above.

Question 31

Private financing is advantageous because:

A)there are more restrictive covenants.
B)it is filed with the provincial securities commissions.
C)the firm is required to provide a detailed prospectus.
D)none of the above

Question 32

A typical five-year revolving line of credit is characterized by:

A)a fixed interest rate for the five years.
B)a floating interest rate, renewed periodically during the five-year term.
C)an interest rate that is lower than the prime rate because these lines of credit are only offered to the most creditworthy firms.
D)b and c

Question 33

Which of the following is the least important for assessing the company's profile for purposes of a line of credit?

A)Current ratio
B)Debt to equity ratio
C)Price to earnings ratio
D)Receivables turnover

Question 34

Use the following statements to answer this question:
I.The major implication of backing money market funds with risky assets is an increase in money market spreads.
II.Bankers' acceptance yields are always lower than commercial paper yields.

A)I and II are correct.
B)I and II are incorrect.
C)I is incorrect and II is correct.
D)I is correct and II is incorrect.

Question 35

Which of the following is an example of a covenant?

A)Requirement to maintain a minimum level of current ratio
B)Requirement to maintain a maximum level of net worth
C)No requirement to limit dividend payments
D)All of the above

Question 36

A junk bond is also known as:

A)a second mortgage
B)a high yield bond
C)a line of credit
D)a subordinated unsecured bond

Question 37

Which of the following is secured by the assets of a firm?

A)Asset-backed commercial paper (ABCP)
B)A fixed interest rate loan
C)A debenture
D)All of the above

Question 38

Which of the following statements is correct?

A)Mortgage bonds and debentures do not differ because they are both debt.
B)In the event of bankruptcy, debenture holders get paid after the claims of preferred shareholders.
C)Mortgages are secured by claims on specific real assets while debentures are not.
D)Debentures are secured by claims on specific real assets while mortgages are not.

Question 39

North American Bat Experts Company (NABE)has just sold a batting machine to a Jamaican cricket team.The team will pay for the machine by borrowing the money from NABE and securing the loan using the machine.This type of debt is called:

A)debenture
B)acceptance
C)purchase-money mortgage
D)line of credit

Question 40

The purpose of a covenant is:

A)to protect the lender in the event of default by the borrower.
B)to protect the borrower in the event of increasing product market competition.
C)to protect the borrower in the event of default by the lender.
D)to protect the borrower in the event of a deterioration of the credit quality of the lender.

Question 41

In determining its rating, DBRS looks at which of the following factors?

A)Core profitability
B)Balance sheet strength
C)Business strength
D)Strategy and management strength
E)All of the above

Question 42

Is it possible for a company to have two debt issues with different debt ratings?

A)No, the rating agency evaluates the creditworthiness of the company.
B)Yes, but only if the company is a multinational and the debt has been issued in different countries.
C)No, the company's credit is the same for all bonds.
D)Yes, the rating agency evaluates the creditworthiness of the issue, not the company.

Question 43

The 30-day T-bill rate is 5 percent.Toronto Skaters has just issued $100 million of commercial paper at par.If the firm defaults, the commercial paper will be worth $5 million.The promised annual yield is 6.15 percent and the required rate of return is equivalent to the T-bill rate.What is the probability of default of Toronto Skaters?

Question 44

List three sources of finance available to corporations in the money market.List one major advantage and one major disadvantage to each source

Question 45

The Globe Theatre Company is negotiating a line of credit with a large bank.The bank is willing to provide credit up to the minimum of 65% of the value of receivables or 70% of the inventory value.If the firm currently has receivables valued at $50 million and inventory valued at $60 million, what is the maximum credit limit available to this firm?

Question 46

You have observed that the credit ratings of firms are very stable over time.However, you have also observed that the earnings of firms are cyclical.Explain how this is possible when credit ratings are supposed to reflect the credit risk of the firm's debt.

Question 47

Use the following statements to answer this question:
I.Debt rating should fluctuate with the economic cycle.
II.Balance sheet strength refers to the ability of the firm to cover its liabilities.

A)I and II are correct.
B)I and II are incorrect.
C)I is incorrect and II is correct.
D)I is correct and II is incorrect.

Question 48

When Collingwood Corp.issued its 60-day commercial paper the promised yield was 9%, whereas the 60-day T-bill yield was 6%.There is a 2% chance that Collingwood will default on this debt.If investors were willing to pay the full par value amount ($1,000)to purchase the paper, how much do they expect to recover in the event of a default?

Question 49

Laurentide Resort Company would like to issue $100 million of commercial paper.Define liquidity support and describe why it would be important to investors.

Question 50

The 30-day T-bill rate is 5%.SWC Company has just issued $100 million of commercial paper at par.There is a 0.1% chance the company will default on the issue.If the firm defaults, the commercial paper will be worth $5 million.Determine the yield spread between the T-bill rate and commercial paper assuming that the required return by investors in commercial paper is equal to the T-bill rate.

Question 51

A bond referred to as a "high yield bond" is most likely:

A)of the highest credit quality
B)of investment grade
C)of satisfactory credit quality
D)of speculative grade

Question 52

Explain the implication of the failure of Lehman Brothers on short-term debt yields, and how it was remedied.