Define each of the following terms:
a. Bond; treasury bond; corporate bond; municipal bond; foreign bond
b. Par value; maturity date; original maturity
c. Coupon payment; coupon interest rate
d. Floating-rate bond; zero coupon bond; original issue discount (OID) bond
e. Call provision; sinking fund provision; indenture
f. Convertible bond; warrant; putable bond; income bond; indexed, or pur-
chasing power, bond
g. Discount bond; premium bond
h. Yield to maturity (YTM); yield to call (YTC); current yield; total return;
yield spread
i. Interest rate risk; reinvestment rate risk; investment horizon
j. Default risk; credit risk
k. Mortgage bond; debenture; subordinated debenture
l. Investment-grade bond; junk bond
ST-2 Bond valuation The Pennington Corporation issued a new series of bonds on
January 1, 1982. The bonds were sold at par ($1,000), had a 12 percent coupon,
and matured in 30 years, on December 31, 2011. Coupon payments are made
semiannually (on June 30 and December 31).
a. What was the YTM on January 1, 1982?
b. What was the price of the bonds on January 1, 1987, 5 years later, assum-
ing that interest rates had fallen to 10 percent?
c. Find the current yield, capital gains yield, and total return on January 1,
1987, given the price as determined in part b.
d. On July 1, 2005, 6.5 years before maturity, Pennington’s bonds sold for
$916.42. What was the YTM, the current yield, the capital gains yield, and
the total return at that time?
e. Now, assume that you plan to purchase an outstanding Pennington bond
on March 1, 2005, when the going rate of interest given its risk was 15.5
percent. How large a check must you write to complete the transaction?
This is a hard question.
237Chapter 7 Bonds and Their Valuation
Chapter 10, where the ideas developed in this chapter are used to help
determine a company’s overall cost of capital, which is a basic component
in the capital budgeting process.
In recent years many companies have used zero coupon bonds to raise
billions of dollars, while bankruptcy is an important consideration for both
companies that issue debt and investors. Therefore, these two related
issues are discussed in detail in Web Appendixes 7A and 7B. Please go to the
Thomson NOW Web site to access these appendixes.ST-3 Sinking fund The Vancouver Development Company (VDC) is planning to sell a $100 million, 10-year, 12 percent, annual payment, bond issue. Provisions for a sinking fund to retire the issue over its life will be included in the indenture. Sinking fund payments will be made at the end of each year, and each payment must be sufficient to retire 10 percent of the original amount of the issue. The last sinking fund payment will
retire the last of the bonds. The bonds to be retired each period can either be purchased on the open market or obtained by calling up to 5 percent of the original issue at par, at VDC’s option.
a. How large must each sinking fund payment be if the company (1) uses the option to call bonds at par or (2) decides to buy bonds on the open market? For part (2), you
can only answer in words.
b. What will happen to debt service requirements per year associated with this issue
over its 10-year life?
c. Now consider an alternative plan, where VDC sets up its sinking fund so that equal
annual amounts are paid into a sinking fund trust held by a bank, with the proceeds
being used to buy government bonds that are expected to pay 7 percent annual
interest. The payments, plus accumulated interest, must total to $100 million at the
end of 10 years, when the proceeds will be used to retire the issue. How large must
the annual sinking fund payments be? Is this amount known with certainty, or
might it be higher or lower?
d. What are the annual cash requirements for covering bond service costs under the
trusteeship arrangement described in part c? (Note: Interest must be paid on
Vancouver’s outstanding bonds but not on bonds that have been retired.) Assume
level interest rates for purposes of answering this question.
e. What would have to happen to interest rates to cause the company to buy bonds on
the open market rather than call them under the plan where some bonds are retired
each year?
