Question 1

Issuing zero coupon bonds might appeal to a company that is considering investing in a long-term project that will not generate positive cash flows for several years.

Accepted Answer

Issuing zero coupon bonds allows a company to raise funds without the burden of periodic interest payments. This may be appealing if the company is investing in a project that will not generate positive cash flows for several years, as it allows them to defer payments until the project starts generating income.

Question 2

Regardless of the size of the coupon payment, the price of a bond moves in the opposite direction from interest rate movements.For example, if interest rates rise, bond prices fall.

Accepted Answer

This is known as an inverse relationship and holds true for all types of bonds, regardless of their coupon payment or maturity date.

Question 3

Typically, debentures have higher interest rates than mortgage bonds primarily because the mortgage bonds are backed by assets while debentures are unsecured.

Accepted Answer

Debentures are unsecured and therefore carry a higher risk for investors. As a result, they typically have higher interest rates than mortgage bonds, which are backed by assets.

Question 4

Floating rate debt is advantageous to investors because the interest rate moves up if market rates rise.Floating rate debt shifts interest rate risk to companies and thus has no advantages for issuers.

Accepted Answer

This statement is incorrect. Floating rate debt can be advantageous for issuers as well, as it allows them to borrow at a lower initial interest rate and potentially benefit from subsequent rate decreases. Additionally, issuing floating rate debt can diversify a company's sources of funding and provide greater flexibility in managing interest rate risk.

Question 5

Eurobonds are typically issued as registered bonds rather than bearer bonds.

Accepted Answer

The answer of Eurobonds are typically issued as registered bonds...

Question 6

LIBOR is an acronym for London Interbank Offer Rate, which is an average of interest rates offered by London banks to S.A.companies.

Accepted Answer

While LIBOR is an average of interest rates offered by banks, it is not specific to South African companies or limited to London banks offering rates to South African companies. LIBOR is a benchmark interest rate used globally for a variety of financial products, including corporate and consumer loans, derivatives, and mortgages.

Question 7

If a firm raises capital by selling new bonds, the buyer is called the "issuing firm," and the coupon rate is generally set equal to the required rate.

Accepted Answer

The buyer of new bonds is not called the "issuing firm," but rather the "bondholder" or "investor." The coupon rate is not necessarily set equal to the required rate, but rather it is set based on market conditions and the creditworthiness of the issuing firm.

Question 8

The motivation for floating rate bonds arose out of the costly experience of the early 1980s when inflation pushed interest rates to very high levels causing sharp declines in the prices of long-term bonds.

Accepted Answer

The statement accurately represents the motivation for floating rate bonds.

Question 9

Foreign debt is a debt instrument sold by a foreign borrower but denominated in the currency of the country in which it is sold.

Accepted Answer

Foreign debt is typically denominated in the currency of the country where it is issued, to attract investors in that country. This may expose the borrower to exchange rate risk if the value of the currency depreciates against their home currency.

Question 10

Eurobonds have a higher level of required disclosure than normally is found for bonds issued in domestic markets, particularly South Africa.

Accepted Answer

Eurobonds typically have less stringent disclosure requirements compared to domestic bonds, as they are issued in international markets and are subject to less regulation.

Question 11

One of the disadvantages to a firm in issuing zero coupon bonds is that the tax shield associated with the bonds' appreciation cannot be claimed until the bond matures.

Accepted Answer

The tax shield associated with the interest expense of zero coupon bonds is recognized annually, even though the interest is not paid until maturity, because the issuer can deduct the imputed interest expense each year for tax purposes.

Question 12

A call provision gives bondholders the right to demand, or "call for," repayment of a bond.Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

Accepted Answer

A call provision gives the issuer of the bond the right, not the bondholder, to repay the bond before its maturity date, typically when interest rates fall, allowing the issuer to refinance at a lower cost.

Question 13

Although ordinary shares represents a riskier investment to an individual than do bonds, in the sense of exposing the firm to the risk of bankruptcy, bonds represent a riskier method of financing to a corporation than ordinary shares do.

Accepted Answer

Bonds require fixed interest payments, increasing financial risk for a corporation, while ordinary shares do not obligate the firm to pay dividends, thus posing less risk of bankruptcy.

Question 14

Restrictive covenants are designed so as to protect both the bondholder and the issuer even though they may constrain the actions of the firm's managers.Such covenants are contained in the bond's indenture.

Accepted Answer

Restrictive covenants are indeed intended to protect both the bondholder and the issuer, and they are typically included in the bond's indenture. While they can limit the freedom of the firm's managers, they can also provide assurances to bondholders that certain actions will not be taken that could undermine the value of their investment.

Question 15

There is an inverse relationship between bond ratings and the required return on a bond.The required return is lowest for AAA rated bonds, and required returns increase as the ratings get lower (worse).

Accepted Answer

This statement is true. The lower the bond rating, the higher the perceived risk of default, and therefore investors require a higher rate of return to compensate for this risk. AAA rated bonds are considered the safest and least likely to default, so investors accept a lower return on investment.

Question 16

Foreign debt is debt sold in a country other than the one in whose currency the debt is denominated.

Accepted Answer

The answer of Foreign debt is debt sold in a...

Question 17

A 20-year original maturity bond with 1 year left to maturity has more interest rate price risk than a 10-year original maturity bond with 1 year left to maturity.(Assume that the bonds have equal default risk and equal coupon rates.)

Accepted Answer

Both bonds have the same duration (time left to maturity) and therefore the same interest rate price risk, assuming all other factors like coupon rates and default risk are equal.

Question 18

In general, long-term unsecured debt is less costly than long-term secured for a particular firm.

Accepted Answer

Long-term secured debt usually has lower interest rates because it is less risky for the lender. In contrast, long-term unsecured debt typically has higher interest rates to compensate for the higher risk to the lender.

Question 19

Eurocredits are bank loans that are denominated in the currency of a country other than where the lending bank is located.

Accepted Answer

Eurocredits are loans that are denominated in a currency other than where the lending bank is located. The term "Euro" in Eurocredit refers to the fact that they were initially denominated in European currencies, but now can be denominated in any foreign currency.

Question 20

Because junk bonds are such high-risk instruments, the returns on such bonds aren't very high and the existence of this market detracts from social welfare.

Accepted Answer

The statement is incorrect. Junk bonds typically offer higher returns than investment grade bonds to compensate for their higher risk, which can be attractive to certain investors. While the existence of the junk bond market may carry some negative consequences, such as greater potential for default and increased borrowing costs for companies, it also provides a means for these companies to access capital and finance growth. Thus, the impact on social welfare is debatable and not necessarily negative.

Quiz 6: Bonds Debt-Characteristics and Valuation