CHAPTER 6/FIXED-INCOME SECURITIES:  59

CHAPTER 6
FIXED-INCOME SECURITIES:
CHARACTERISTICS AND VALUATION
ANSWERS TO QUESTIONS:

1. a Indenture - the contract between the issuing firm and the lenders in a debt obligation,
specifying the nature of the debt issue, the manner in which the principal must be paid, and the
restrictions (covenants) placed on the firm by the lenders.
b. Trustee - the bondholders representative in a public debt offering. The trustee is responsible for
monitoring the borrower's compliance with the terms of the indenture.
c. Call feature - a provision that permits the bond issuer to retire the obligation prior to its
maturity.
d. Sinking fund - a method of providing for the gradual retirement of a bond issue. The sinking
fund requirement can be met by depositing a certain amount of money annually in a sinking
fund account. Alternatively, the firm can either purchase a portion of the debt each year in the
open market or, if the debt is callable, use a lottery technique to determine which actual bonds
will be called and retired each year.
e. Conversion feature - a provision that allows the holder to exchange the bond for shares of the
company's common stock at the option of the holder.
f. Coupon rate - the annual rate of interest paid to bondholders. It is expressed as a percentage
of par value.

2. a. Mortgage bond - a debt issue that is secured by specific physical assets of the issuing company.
b. Debenture - an unsecured debt issue. The quality of the debt issue depends on the general
credit-worthiness of the issuing company.
c. Subordinated debenture - an unsecured debt issue that is “junior” to other types of debt. In the
event of liquidation or reorganization of the company, claims of subordinated debenture
holders are considered only after the claims of unsubordinated debt holders
d. Equipment trust certificate - used largely by railroad and trucking companies to purchase
specific assets, such as rolling stock. The certificate holders own the equipment and lease it to
the company.
e. Collateral trust bond - a bond that is backed by stocks or bonds of other corporations. This
type of bond is used primarily by holding companies.
f. Income bond - a bond that promises to pay interest only if the issuing firm earns sufficient
income, otherwise no interest obligation exists. This type of bond often is created in
reorganizations following bankruptcy and normally is issued in exchange for junior or
subordinated issues.

3. Investors would have a potential tradeoff between the 9 1/8% senior issue (which promises less
return and is less risky than the subordinated issue) and the 9 3/8% senior subordinated issue
(which promises more return and is more risky than the 9 1/8% senior issue).

4. a Long-term debt - Most long-term debt is issued at par and put on the firm's books at par. At
60  CHAPTER 6/FIXED-INCOME SECURITIES:

the time of issue, the coupon rate is set so that the debt is sold at a price close to par value.
Over time the market value decreases when interest rates increase, and vice-versa.
b. Preferred stock - Some preferred stock is issued at par and put on the firm's books at par.
Other preferred stock is issued and put on the books at some "stated value". The market value
increases (decreases) as dividend yields on similar quality preferred issues decrease (increase).

5. a. Cumulative feature - a provision which provides that if a firm fails to pay its preferred
dividend, it cannot pay dividends on its common stock until it has satisfied all (or a pre-
specified portion of) past-due preferred dividends.
b. Participation - a preferred stock issue in which the holders share in any increased earnings of
the company. Virtually all preferred stock is nonparticipating.
c. Call feature - a provision that gives the company the option to redeem (i.e., retire) its
preferred stock issue at some specified price.

6. The variables which must be known (or estimated) are the expected cash returns during each
period, the required rate of return (discount rate), and the holding period of the asset.

7. a Market value of an asset is the value placed on the asset by the marginally satisfied buyer and
seller and occurs at the intersection of the demand and supply schedules.
b. Market equilibrium occurs at a point in time when there is no tendency for the price of the
asset to move higher or lower, i.e., when the expected rate of return on the asset is equal to the
(marginal) investor's required rate of return.

8. Book value is a function of the historical acquisition cost of the asset, whereas market value is a
function of the expected future returns of the asset. Market value may be greater than or less than
book value depending on the changes that occur over time in the market capitalization rate and
asset's expected future returns.

9. a A bond will sell at a discount if the required rate of return is greater than the coupon rate.
b. A bond will sell at par value if the required rate of return is equal to the coupon rate.
c. A bond will sell at a premium if the required rate of return is less than the coupon rate.

10. The yield-to-maturity is the rate of return expected to be earned if a bond is purchased at a given
price and held until maturity. The coupon or current yield is equal to the annual interest payment
divided by the current price. Yield-to-maturity takes into account interest returns as well as any
capital gains (or losses) over the remaining life of the bond. The coupon or current yield considers
only the interest returns and ignores any capital gains (or losses).

11. The current yield will be equal to the yield to maturity when the current price of the bond is equal
to its par, or maturity, value. In this case there will be no capital gain (or loss) when the bond
matures.

12. Preferred stock is similar to long-term debt in that dividends on preferred stock, like interest on
debt, usually remain constant over time. Likewise, both securities have a fixed claim on the assets
of the firm in the event of bankruptcy. Thus, preferred stock and long-term debt are considered
fixed income securities.

Preferred stock is similar to common stock in that it is part of stockholders' equity. Also, holders
 CHAPTER 6/FIXED-INCOME SECURITIES:  61

of preferred stock receive returns in the form of dividends rather than interest.

13. A sinking fund provision is used to reduce the amount owed on the maturity date and hence
reduce the risk that the borrower will default on the bond issue. Also, a sinking fund provision
may add liquidity to a bond issue if the company satisfies its sinking fund obligation by buying the
bonds in the open market.

14. Interest rate risk represents the variation in the market price of a bond and hence its realized rate
of return (if sold prior to maturity) due to changes in prevailing interest rates (i.e., required rates
of return).

15. A bond is classified as a fixed income security because the holder expects to receive constant
interest payments each period. If the bond is held until maturity, the realized rate of return is
independent of fluctuations over time in the market price of the bond.

16. a Floating rate bonds - bonds with coupon rates that are adjusted periodically (e.g. quarterly)
based on changes in interest rates. This feature protects investors against a rise in interest rates
because the prices of the bonds will not fluctuate as much as do fixed coupon rate bonds.
b. Original issue deep discount bonds - bonds that have coupon rates below prevailing interest
rates at the time of issue and hence sell initially at a discount from par value.
c. Zero coupon bonds - bonds that pay no explicit rate of interest and are sold at a substantial
discount from par when initially issued.
d. Extendable notes (put bonds) - bonds that are redeemable at par value at the option of the
owner at pre-specified times or under specified conditions. Put bonds often pay interest at a
floating coupon rate.

17.  Reinvestment rate risk is the potential decrease in interest income that results when a bond
issue matures (or is called) and, because of a possible decline in interest rates, the investor has
to reinvest the principal at a lower coupon rate.

18. No recommended solution.

62  CHAPTER 6/FIXED-INCOME SECURITIES:

SOLUTIONS TO PROBLEMS:
1. a. Po = I/kd

I = $1000 X .04 = $40

kd = .04

Po = $40/.04 = $1000

b. I = $40kd = .05

Po = $40/.05 = $800

c. I = $40 kd = .06

Po = $40/.06 = $666.67

2. a. kd = I/Po

I = $40Po = $790

kd = $40/$790 = 0.0506 (or 5.06%)

b. I = $40Po = $475

kd = $40/$475 = 0.0842 (or 8.42%)

n
3. a. Po =  I/(1 + kd)t + M/(1 + kd)n
t=1

I = .0875 X 1000 = $87.50 kd = 0.07

M = $1000n = 12 years (2012 - 2004)

12
Po =  87.50/(1 + 0.07)t + 1000/(1 + 0.07)12
t=1
 CHAPTER 6/FIXED-INCOME SECURITIES:  63

= 87.50(PVIFA.07,12) + 1000 (PVIF.07,12)

= 87.50(7.943) + 1000 (0.444) = $1139

b. I = $87.50 kd = .09 M = $1000 n = 12

12
Po =  87.50/(1 + .09)t + 1000/(1 + 0.09)12
t=1

= 87.50 (PVIFA0.09,12) + 1000(PVIF0.09,12)

= 87.50(7.161) + 1000 (0.356) = $983

c. I = $87.50 kd = .11 M = $1000 n = 12

12
Po =  87.50/(1 + 0.11)t + 1000/(1 + 0.11)12
t=1

= 87.50 (PVIFA0.11,12) + 1000(PVIF0.11,12)

= 87.50(6.492) + 1000 (0.286) = $854

d. I = .0875(1000)/2 = $43.75 M = $1000

kd = 0.08/2 = 0.04; n = 12 X 2 = 24

24
Po =  43.75/(1 + 0.04)t + 1000/(1 + 0.04)24
t=1

= 43.75(PVIFA0.04,24) + 1000(PVIF0.04,24)

= 43.75(15.247) + 1000(0.390) = $1057

** Note: This solution assumes that 8 percent is the nominal return requirement, not the effective
return requirement. If 8 percent is the effective return requirement, then the semi-annual
discount rate would be 3.92 percent.
64  CHAPTER 6/FIXED-INCOME SECURITIES:

n
4. P0 =  It/(1 + kd)t + M/(1 + kd)n
t= 1

n = 15 kd = 0.11 M = $1000

It = 0.10(1000) = $100 t = 1-5

It = 0.1075(1000) = $107.50 t = 6-10

It = 0.115(1000) = $115 t = 11-15

5 10
P0 =  100/(1 + 0.11)t +  107.50/(1 + 0.11)t
t=1 t=6

15
+  115/(1 + 0.11)t + 1000/(1 + 0.11)15
t=11

= 100(PVIFA.11,5) + 107.50[(PVIFA.11,10) - (PVIFA.11,5)]

+ 115[(PVIFA.11,15) - (PVIFA.11,10)] + 1000 (PVIF.11,15)

= 100(3.696) + 107.50(5.889 - 3.696) + 115(7.191 - 5.889)

+ 1000(0.209)

= $964

n
5. Po =  I/(1 + kd)t + M/(1 + kd)n
t=1

kd = yield-to-maturity

I = 0.07375(1000) = $73.75 n = 32 (2033 - 2001)

M = $1000 Po = $900
 CHAPTER 6/FIXED-INCOME SECURITIES:  65

kd = 8.27% (by calculator)

n
6. a. Po =  I/(1 + kd)t + M/(1 + kd)n
t=1

kd = yield-to-maturity

I = 0.08125(1000) = $81.25 n = 20 (2024 - 2004)

M = $1000 Po = $1025

kd = 7.87 % (by calculator)

7. a. Po = M/(1 + kd)n

= M(PVIFk ,n)
d

n = 18 (2008 - 1990); Po = $100; M = $1000

$100 = $1000(PVIFk ,18)

d

(PVIFk ,18) = 0.100

d

From Table II, this present value interest factor in the 18-year row is between the values for
13% (0.111) and 14% (0.095). Calculator solution is kd = 13.65 %.

b. Po = $750; n = 4 (2008 - 2004)

$750 = $1000(PVIFk ,4)

d

(PVIFk ,4) = 0.750

d

kd = 7.46% (by calculator)

c. Over the period from 1985 to 1999, the general level of interest rates declined, causing bond
prices to rise and yields to fall.
66  CHAPTER 6/FIXED-INCOME SECURITIES:

8. Po = M/(1 + kd)n

= M(PVIFk ,n)
d

n = 11 Po = $225 M = $1000

$225 = $1,000(PVIFk ,11)

d

(PVIFk ,11) = 0.225

d
From Table II, this present value interest factor (in the 11-year row) lies between the value in the
14% and 15% columns.

Interpolation yields:

kd = 14% + [(0.237 - 0.225)/(0.237 - 0.215)](15% - 14%)

= 14.5% or 14.52% (by calculator)

9. a. kd = yield-to-maturity

I = 0.08625($1000) = $86.25;n = 20 (2031 - 2001)

M = $1,000; P0 = $1,050

kd = 8.11% (by calculator)

An investor will purchase this bond if its promised yield to maturity equals or exceeds the
investor’s required rate of return.

b. kc = yield-to-call

I = 0.0865($1000) = $86.25; n = 5 (2006 - 2001)

Call price = $1,044.50; P0 = $1,050

kc = 8.13% (by calculator)

10. a. P0 = Dp/kp

Dp = $3.5 kp = 0.09

P0 = $3.5/0.09 = $38.89
 CHAPTER 6/FIXED-INCOME SECURITIES:  67

b. Dp = $3.5 kp = 0.10

P0 = $3.5/0.10 = $35.

c. Dp = $3.5 kp = 0.12

P0 = $3.5/0.12 = $29.17

11. P0 = Dp/kp

Dp = $4.50; kp = 0.09

P0 = $4.50/0.09 = $50

12. I = $81.25; n = 6 (2010-2004); P0 = $1,025; Call price = $1,016.55

kd = 7.81%

13. a. YTM = 7.75%

b. $900 = $77.50(PVIFAk ,5) + $1000(PVIFk ,5)
d d

YTM = 10.41 % (by calculator)

c. $1050 = $77.50(PVIFAk ,5) + $1000(PVIFk ,5)
d d

YTM = 6.54% (by calculator)

14. Value, assuming stock is redeemed in 10 years at $30 a share:

Po = $2.50(PVIFA0.15,10) + $30(PVIF0.15,10)

= $2.50(5.019) + $30(0.247)

= $19.96

Value, assuming stock is called in 15 years at $32.50 a share:

Po = $2.50(PVIFA0.15,15) + $32.50(PVIF0.15,15)

= $2.50(5.847) + $32.50(0.123)

= $18.62

Therefore, the current market value is $19.96, or approximately $20 a share, because
knowledgeable investors will plan to exercise their redemption option.
68  CHAPTER 6/FIXED-INCOME SECURITIES:

15. a. Po= $105(PVIFA0.14,20) + $1000(PVIF0.14,20)

= $105(6.623) + $1000(0.073)

= $768

b. Po = $105(PVIFA0.14, 10) + $1100(PVIF0.14, 10)

= $105 (5.216) + $1100(0.270)

= $845

16. Po = $120(PVIFA0.10,8) + $1120(PVIF0.10,8)

= $120(5.335) + $1120(0.467)

= $1,163

17. Option 1: Hold to maturity

P0 = $80(PVIFA.082,12) + $1,000(PVIF.082,12)

= $985 (by calculator)

Option 2: Redeem in 5 years

P0 = $80(PVIFA.09,5) + $1,000(PVIF.09,5)

= $961 (by calculator)

Since the option for early redemption is the bondholders, the value must be the higher of the two,
or $985.

18. P0 = $0.84(PVIFA.12,5) + $14(PVIF.12,5)

= $10.97

19. Maximum value:

P0 = $150(PVIFA.11,25) + $1000(PVIF.11,25)

= $1337

Value at call = $1,1000

 CHAPTER 6/FIXED-INCOME SECURITIES:  69

You would pay $1,100 or perhaps a slight premium over that amount, but nowhere near $1,337,
due to the imminent risk of a call of the bonds.

20. a. ATT: 8.125%; 2024

Borden: 8.375%; 2016

Crown Cork: 7.375%; 2026

Honeywell: 0%; 2005

Noram: 6%; 2012

b. $44 x 10 = $440

c. Crown Cork and Seal bonds are subject to greater default risk than ATT bonds.

d. $4 x 10 = $40 increase.

21. A 3.02 percent rate reflects a discount from maturity value of $302 for a one year Treasury bill.
The discount would be half that amount or $151 for a 6-month bill, resulting in an asked price of
$9,849.

22. A price of 147-27 is equal to 147 27/32 percent of par, or $1,478.44, plus any accrued interest.

23. a. These are zero coupon bonds that pay no explicit interest.
b. The bonds are sold at a discount and increase in value toward par value ($1,000) over their
life. Thus, the bondholders’ sole source or return is price appreciation.

24. Investors are speculating that the bonds will be worth more than $1000 when the firm is either
liquidated or reorganized.

25. The “cv” indication means that the bond is convertible into common stock under certain
conditions. Convertible bonds are sold by a firm that wishes to save on its interest costs. (Yields
on convertible bonds typically are lower than yields on similar quality and maturity non-convertible
bonds.) In addition, the issuer of convertible bonds hopes that ultimately the bondholders will
convert, thereby converting the debt obligation on the balance sheet to equity.

26. a. P0 = $1,050; M = $1,000; n = 90 (2093 – 2003)

I = 0.0755 ( $1,000) = $75.50

By calculator the yield to maturity = 7.19%.

b. P0 = 1050 = $75.50 / YTM

70  CHAPTER 6/FIXED-INCOME SECURITIES:

YTM = 7.19%

c. The present value of the principal ( $1,000) in 90 years is relatively small, because of the
effects of time and discounting. In fact, the present value of $1000 received 90 years from now
is only $1.93, when discounted at the bond’s YTM of 7.19 percent, whereas the present value
of the firm’s interest payments of $75.50 per year for 90 years is $1048.04.

27. Compute the value of the bond at a 20 percent required return:

P0 = $90 (PVIFA0.20, 17) + $1,000 (PVIF0.20, 17)

P0 = $474.79 (by calculator)

Therefore invest because the value to you is greater than the current market price of $400. The
call price is not relevant because the company is unlikely to call the bonds at the current market
price.