1. If a firm could sell a mortgage bond at an 8% interest rate, it could sell an otherwise...

Question:

1. If a firm could sell a mortgage bond at an 8% interest rate, it could sell an otherwise identical debenture at:

i. a rate less than 8%

ii. 8%

iii. a rate greater than 8%

iv. cannot be determined

2. Two years ago, Trans-Atlantic Airlines sold $250 million worth of bonds at $1,000 each. The bonds had a maturity of 12 years and a coupon rate of 12%. Today these bonds are selling for $910. Determine the yield-to-maturity (to the nearest tenth of one percent).

i.13.2%

ii. 5.6%

iii. 13.7%

iv. 12.0%

3. Assume that the dividend on Central Power Company's $4.68 preferred stock issue is paid annually at the end of the year. Determine the value of this preferred stock to an investor who requires a 12 percent rate of return.

i. $3.25

ii. $39

iii. $12

iv. $27.08

Maturity Risk Premium:

Maturity risk is the risk associated with investing in an investment that has a long duration. All else the same, an investment with a longer duration is subject to a higher risk, and hence must command a higher return.

Answer and Explanation:

Question 1

The answer is i).

A debenture has a shorter term to maturity than a mortgage bond. All else the same, a bond with a longer term to maturity will have a higher yield because of the maturity risk premium. Therefore, a debenture will have a lower interest rate than an otherwise identical bond.

Question 2

The answer is iii).

The yield to maturity is the discount rate that equates the present value of the bond to its current price. The bond has 1000 par value, 1000*12% = 120 annual coupon, and current price of 910. The bond has 10 years to maturity. The yield to maturity is the solution to the following equation:

  • {eq}\displaystyle \frac{120*(1 - (1 + y)^{-10})}{y} = 910 {/eq}

which yields:

  • {eq}y = 13.71\% {/eq}

Question 3

The answer is ii).

The price of a preferred stock is calculated as follows:

  • price per share = dividend per share / required return
  • price per share = 4.68 / 12%
  • price per share = 39

Learn more about this topic:

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How to Calculate Risk Premium: Definition & Formula

from Financial Accounting: Help and Review

Chapter 5 / Lesson 26
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