Chapter 8

Question 1

What is the Fisher Effect formula?

Answer 1

(1 + R) = (1 + r)(1 + h), where R = nominal rate, r = real rate, h = inflation.

Question 2

What is the main cost of equity?

Answer 2

Loss of ownership control and profit-sharing with shareholders.

Question 3

How do you value a coupon bond?

Answer 3

Add the present value of coupon payment annuity and the present value of the face value.

Question 4

What is the inflation premium in bond yields?

Answer 4

Extra return to compensate for expected inflation.

Question 5

What’s the taxability premium in bond yields?

Answer 5

Extra yield on taxable bonds versus tax-exempt ones (e.g., municipal bonds).

Question 6

What is a debenture?

Answer 6

An unsecured bond backed only by the issuer’s creditworthiness.

Question 7

What is the approximate Fisher Effect formula?

Answer 7

R ≈ r + h.

Question 8

What happens to bond prices when interest rates increase?

Answer 8

Bond prices decrease (inverse relationship).

Question 9

What is a zero-coupon bond?

Answer 9

A bond with no periodic interest payments; return is from price difference and par value.

Question 10

What is equity?

Answer 10

ownership, voting rights, non-taxable dividends, no legal obligation to pay.

Question 11

What does a higher bond rating typically indicate?

Answer 11

Lower default risk and lower yield required by investors.

Question 12

What are the six factors affecting bond yields?

Answer 12

Real interest rate, inflation premium, interest rate risk premium, default risk premium, taxability premium, liquidity premium.

Question 13

What is the formula for the value of a coupon bond?

Answer 13

PV of coupon annuity + PV of face value.

Question 14

What is financial distress in terms of debt?

Answer 14

A condition where a firm struggles to meet debt obligations, potentially leading to bankruptcy.

Question 15

What are the types of U.S. Treasury securities?

Answer 15

T-bills (<1 year), T-notes (1–10 years), T-bonds (>10 years).

Question 16

What is the par value of most bonds?

Answer 16

$1,000 (unless stated otherwise).

Question 17

What is a liquidity premium?

Answer 17

Additional yield on less easily tradable (illiquid) bonds.

Question 18

What is the first principle of valuing financial securities?

Answer 18

Value = Present value of expected future cash flows.

Question 19

How do you calculate YTM in Excel?

Answer 19

Use the function =YIELD(settlement, maturity, rate, pr, redemption, frequency).

Question 20

What does the Excel function =PRICE do?

Answer 20

Calculates the price of a bond based on settlement, maturity, coupon, yield, etc.

Question 21

What is debt?

Answer 21

no ownership, tax-deductible interest, legal recourse

Question 22

Why do low-coupon bonds have higher price risk?

Answer 22

They pay less interest over time, so more of their value depends on the discounted par.

Question 23

What does a coupon bond pay?

Answer 23

Periodic interest payments (coupons) and the face value at maturity.

Question 24

What happens when YTM < coupon rate?

Answer 24

The bond trades at a premium.

Question 25

When are secured bonds likely to have lower coupon rates?

Answer 25

When compared to unsecured (debenture) or subordinated debt due to lower risk.

Question 26

What is price risk?

Answer 26

The risk of bond price changes due to fluctuations in interest rates.

Question 27

What is yield to maturity (YTM)?

Answer 27

The discount rate that equates the bond price with the present value of future cash flows.

Question 28

What does the nominal interest rate include?

Answer 28

Both real interest rate and expected inflation.

Question 29

What’s the difference between debt and equity?

Answer 29

Debt = no ownership, tax-deductible interest, legal recourse. Equity = ownership, voting rights, non-taxable dividends, no legal obligation to pay.

Question 30

What happens when YTM > coupon rate?

Answer 30

The bond trades at a discount.

Question 31

What types of bonds have more interest rate risk?

Answer 31

Long-term and low-coupon bonds.

Question 32

What is the purpose of bond ratings?

Answer 32

To assess the creditworthiness and default risk of a bond issuer.

Question 33

What does bond pricing rely on, regardless of coupon?

Answer 33

Risk and time to maturity; similar risk bonds should yield similarly.

Question 34

What is a bond?

Answer 34

A legally binding agreement between a borrower and lender, typically with a par value, coupon rate, and maturity date.

Question 35

What is senior debt?

Answer 35

Debt that has priority in claims over other types of debt in case of liquidation.

Question 36

Are dividends tax-deductible for a company?

Answer 36

No, unlike interest payments on debt.

Question 37

What does the coupon rate represent?

Answer 37

The annual interest paid as a percentage of the par value.

Question 38

What kind of bonds have the lowest interest rate risk?

Answer 38

Short-term, high-coupon bonds.

Question 39

What happens when YTM = coupon rate?

Answer 39

The bond trades at par.

Question 40

What does “subordinated” mean in terms of bonds?

Answer 40

Lower priority in repayment compared to senior debt.

Question 41

How do interest rates affect long-term vs. short-term bonds?

Answer 41

Long-term bonds are more sensitive to interest rate changes.

Question 42

What is the main benefit of issuing equity instead of debt?

Answer 42

No obligation to make fixed payments, reducing bankruptcy risk.