AFM101 Chapter Notes - Chapter 11: Effective Interest Rate, Callable Bond, Interest Expense

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blueraccoon878

5 Jan 2017

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM101

Professor

Donna Psutka

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AFM101 Full Course Notes

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Bond principle/par value/face amount: amount payable at maturity of bond, and basis of computing periodic cash interest payments. Bonds usually require payment of interest over its life, with repayment of principal on maturity date. Stated rate/coupon rate/contract rate: rate of interest per period specified in the bond contract. Debenture (aka unsecured bond): no collaterals pledged to guarantee repayment at maturity. Secured bond: collateral pledged to guarantee repayment at maturity. Callable bond: may be collected earlier than maturity date by issuer. Convertible bond: may be converted to other securities of issues (i. e. common shares). Indenture: bond contract that specifies legal provisions of bond issue. Provisions include maturity date, rate of interest to be paid, date of each interest payment, and any conversion privileges. Bond certificate: document given to investor for issuance of bond. Compute present value of principle (a single payment) and present value of interest payments (an annuity)

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Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

When interest rates move up or down, bond prices move in the _________________ direction.

_____________ are referred to as non-amortized debt, which means interest is paid regularly during the term, usually semiannually, whereas repayment of principal does not occur until the maturity date.

The longer a bond has to maturity, _______________ sensitive the bondâs price is to changes in market interest rates. This is called ________________________.

Bonds with short maturities expose investors to high ____________________, which is the risk that income from a bond portfolio will decline because cash flows received from bonds will be rolled over at lower interest rates.

A bond with an annual coupon payment of $100 originally sold at par for $1,000. Market interest rates are currently 12%. This bond would be selling at a _____________ in order to compensate the purchaser for the below market coupon rate.

Once a bond has been issued, if the holder of the bond retains it until maturity the market value of the bond may ________________, but the ________________ will not.

An unsecured bond is referred to as a(n) __________________.

____________________ can generally be issued at somewhat lower interest rates than regular bonds.

Double-B and lower bonds are speculative, to be called _______________.

Bonds are assigned _____________ that reflect the probability of their going into default. The higher it is, the lower its risk and therefore its interest rate.

When the yield curve slopes upward, it is said to be _______________, because it is like this most of the time. Conversely, a downward-slopping yield curve is termed ______________.

The (-Select- A. discount B. premium C. par) value of a bond is its stated face value or maturity value, and its coupon interest rate is the stated annual interest rate on the bond. The maturity date is the date on which the par value must be repaid. A (-Select- A. call B. redemption C. sinking) provision gives the issuer the right to redeem the bonds under specified terms prior to their normal maturity date, although not all bonds have this provision. Some bonds have (-Select- A. redemption fund B. sinking fund C. call fund) provisions which require the issuer to systematically retire a portion of the bond issue each year. Because sinking fund provisions facilitate their orderly retirement, bonds with these provisions are regarded as being (-Select-A. riskier B. safer C. equivalent) so they will have (-Select- A. lower B. equivalent C. higher) coupon rates than similar bonds without these provisions.

Bonds can be (-Select- A. floating B. zero C. fixed) -rate bonds with a constant coupon rate over the life of the bond, or they can be (-Select- A. floating B. zero C. fixed) -rate bonds with a coupon rate that varies over time depending on the level of interest rates. (-Select- A. Annual coupon B. Zero coupon C. Fixed coupon) bonds pay no annual interest but are sold at a (-Select- A. premium above B. price at C. discount below) par, thus compensating investors in the form of capital appreciation. An original issue discount (OID) bond is any bond originally offered at a price (-Select- A. above its B. below its C. equal to) par value.

(-Select- A. Convertible B. Perpetual C. Putable) bonds are exchangeable at the option of the holder for the issuing firm's common stock. Bonds can be issued with warrants giving the holder the option to purchase the firm's stock for a stated price, thereby providing a capital gain if the stock's price rises. (-Select- A. Income B. Convertible C. Putable) bonds contain a provision that allows holders to sell them back to the company prior to maturity at a prearranged price. (-Select- A. Income B. Default C. Preferred) bonds pay interest only if the firm has earnings, while an indexed (purchasing power) bond bases interest payments on an inflation index to protect the holder from inflation.

Mortgage bonds are backed by (-Select- A. current assets B. fixed assets C. marketable securities) . First mortgage bonds are senior in priority to claims of second mortgage bonds. Debentures are long-term bonds that are not secured by a mortgage. Subordinated debentures are bonds having claims on assets only after senior debt has been paid in full in the event of liquidation. (-Select- A. Secured-debenture B. Investment-grade) bonds are rated triple B or higher, and many banks and other institutional investors are legally limited to only holding these bonds. In contrast, junk bonds are high-risk, high-yield bonds.

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1. When convertible debt is not converted at maturity

a. a gain or loss is recorded for the difference between thebook value of the debt and the present value of the cash flows.

b. the amount originally allocated to equity is recorded as again on retirement.

c. the amount allocated to the equity component atthe issuance date is recorded as a loss on retirement.

d. the carrying value of the bond equals its face value and itis removed from the books.

2. Mae Jong Corp issues $1,000,000 of 10% bonds payable whichmay be converted into 10,000 shares of $2 par value ordinaryshares. The market rate of interest on similar bonds is 12%.Interest is payable annually on December 31, and the bonds wereissued for total proceeds of $1,000,000. In accounting for thesebonds, Mae Jong Corp. will

a. First assign a value of the equity component, then determinethe liability component.

b. Assign no value to the equity component since the conversionprivilege is not separable from the bond.

c. First assign a value to the liability component based on theface amount of the bond.

d. Use the

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AFM101 Chapter Notes - Chapter 11: Effective Interest Rate, Callable Bond, Interest Expense

AFM101 Full Course Notes

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