SECTION I Conceptual Questions 8 Points each 1. The required rate of return on a
ID: 2783739 • Letter: S
Question
SECTION I
Conceptual Questions 8 Points each
1. The required rate of return on an asset is a function of
A) The risk associated with the return from the given asset
B) The established risk-free rate of interest
C) The market equilibrium
D) Both a and b above are correct
ANSWER:
2. At any point in time before maturity of a bond, the bond could be selling at
A) A premium
B) At a discount
C) At par
D) Any of the above
E) None of the above
ANSWER:
3.. A zero coupon bond is a bond that
a. originally sold at a discount
B. will sell for a premium
c.. is a premium value bond
d.. has a high current yield
ANSWER:
4.. With respect to a corporate bond, a sinking fund allows the issuer to
A) redeem an entire debt issue prior to maturity
B) purchase a portion of the debt each year in the open market or call a portion of the debt for mandatory redemption
C) call the entire debt issue
D) accumulate interest expenses into a sinking fund account
ANSWER:
5. Users of preferred stock include (Hint: see Chapter 6 in the e-text):
a. Utility companies
b.. Acquiring firm in mergers and acquisitions
c. Large commercial banks
d. All of the above
e. None of the above
ANSWER:
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Section II
7. (10 Points) What is the yield to maturity for the Cornwall Linkage Company zero coupon $1,000 bond that matures in 14 years assuming that the bond is currently selling for $530.00 (hint: this bond does not have a coupon rate and therefore, only a maturity value and no regular cash flows)?
…………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………… $___________
8. (30 points). Cornwall Agency issued $50 million of 20-year corporate bonds in 2010. The bonds were issued in $1000 denominations with an annual coupon interest rate of 8%. Give your answers to a, b, and c below:
What is the current rate of return also called the current yield on these bonds if they are purchased at a current price of $900 each?
……………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………… $___________
b.. Value the bond, that is, find the intrinsic value (Vb) of the $1,000 bond assuming a client is requiring an interest rate of 11.5%. You could use the Excel spreadsheet, a financial calculator or the formula as we did in the study of time value of money (TVM). Note that the bond has 13 more years to expire and therefore N = 13 and the market price is $900.
…………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………… $___________
c.. From the results in (b) above would you recommend her to invest in the bond?
YES ________ NO _______
YOUR REASONING IS: ………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………
SECTION III
(20 Points). In 15 years’ time you wish to purchase a house in Avalon Park, FL currently valued at $180,000. The value of the asset is expected to increase at a growth rate of 2.75% per year. You wish to set aside equal end-of-monthly payments so that in 15 years’ time you would buy the house for cash. What is the equal monthly amounts to set aside, assuming that you could earn a 9% return on your set aside amounts over the period? This simulation is best handled in two parts, as we did in class, as follows:
Projected asset value:
……………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………….………………………………………$_________
Set Aside end-of-month payments (PMT) would be:
…………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………... $___________
Explanation / Answer
1. The required rate of return on an asset is a function of
D) Both a and b above are correct
As return is dependent on risk free rate and risk associated with the security. for example, CAPM uses market risk premium and risk relative to the market
2. At any point in time before maturity of a bond, the bond could be selling at
D) Any of the above
Depending on the yield or interest rates, bond might be selling at discount or premium or par. If yield is more than coupon rate, bond will sell at discount if yield is less than coupon rate, bond will sell at premium. if yield is same as coupon rate, bond will sell at par
3.. A zero coupon bond is a bond that
a. originally sold at a discount
As zero coupon pays no coupons, it is oirignally sold at dicsount and redeemed at face value so that the difference is the interest
4.. With respect to a corporate bond, a sinking fund allows the issuer to
B) purchase a portion of the debt each year in the open market or call a portion of the debt for mandatory redemption
Sinking fund allows repaying debt through periodic payments to trustee who retires part of issue by purchasing bonds in open market.
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