A curve on a graph with the rate of return on the vertical axis and time on the horizontal axis depicts
Answer (B) is correct. The term structure of interest rates is the relationship between long- and short-term interest rates, that is, between yield to maturity and time to maturity. It is graphically depicted by a yield curve with a rate of return on the vertical axis and time to maturity on the horizontal axis. If short-term rates are higher than long-term rates, the curve will be downward sloping. If the reverse is true, the curve will be upward sloping.
A downward-sloping yield curve depicting the term structure of interest rates implies that
Answer (D) is correct. The term structure of interest rates is the relationship between long- and short-term interest rates, that is, between yield to maturity and time to maturity. It is graphically depicted by a yield curve with a rate of return on the vertical axis and time to maturity on the horizontal axis. If short-term rates are higher than long-term rates, the curve will be downward sloping. If the reverse is true, the curve will be upward sloping.
Short-term interest rates are
Answer (A) is correct. Historically, one facet of the term structure of interest rates (the relationship of yield and time to maturity) is that short-term interest rates have ordinarily been
lower than long-term rates. One reason is that less risk is involved in the short run. Moreover, future expectations concerning interest rates affect the term structure. Most economists believe that a long-term interest rate is an average of future expected short-term interest rates. For this reason, the yield curve will slope upward if future rates are expected to rise, downward if interest rates are anticipated to fall, and remain flat if investors think the rate is stable. Future inflation is incorporated into this relationship. Another consideration is liquidity preference: Investors in an uncertain world will accept lower rates on short-term investments because of their greater liquidity, whereas business debtors often prefer to pay higher rates on long-term debt to avoid the hazards of short-term maturities.
Which of the following scenarios would encourage a company to use short-term loans to retire its 10-year bonds that have 5 years until maturity?
Answer (C) is correct. If interest rates have declined, refunding with short-term debt may be appropriate. The bonds pay a higher interest rate than the new short-term debt. Assuming that rates continue to fall, the short-term debt can itself be refunded with debt having a still lower interest charge. The obvious risk is that interest rates may rise, thereby compelling the company to choose between paying off the debt or refunding it at higher rates.
The term “underwriting spread” refers to the
Answer (C) is correct. An investment banker performs an underwriting or insurance function when it
purchases an issue of securities and then resells them. The risk of price fluctuations during the distribution period is borne entirely by the investment banker. Investment banking is also an efficient vehicle for marketing the securities because investment bankers are specialists in such activities. The profit earned is the underwriting spread, or the difference between the purchase and resale prices of the securities (effectively, the wholesale and retail prices).
Which one of the following characteristics distinguishes income bonds from other bonds?
Answer (D) is correct. An income bond is one that pays interest only if the issuing company has earned the interest, although the principal must still be paid on the due date. Such bonds are riskier than normal bonds.
From an investor’s viewpoint, the least risky type of bond in which to invest is a(n)
Answer (D) is correct. A secured bond is backed by tangible property, making it the safest type for the investor of the four listed.
Serial bonds are attractive to investors because
Answer (C) is correct. Serial bonds have staggered maturities; that is, they mature over a period (series) of years. Thus, investors can choose the maturity date that meets their investment needs. For example, an investor who will have a child starting college in 16 years can choose bonds that mature in 16 years.
If Brewer Corporation’s bonds are currently yielding 8% in the marketplace, why is the firm’s cost of debt lower?
Answer (D) is correct. Because interest is deductible for tax purposes, the actual cost of debt capital is the net effect of the interest payment and the offsetting tax deduction. The actual cost of debt equals the interest rate times (1 – the marginal tax rate). Thus, if a firm with an 8% market rate is in a 40% tax bracket, the net cost of the debt capital is 4.8% [8% × (1.0 – .40 .
Answer (C) is correct. Debentures are unsecured bonds. Although no assets are mortgaged as security for the bonds, debentures are secured by the full faith and credit of the issuing firm. Debentures are a general obligation of the borrower. Only companies with the best credit ratings can issue debentures because only the company’s credit rating and reputation secure the bonds.