ST-1 KEY TERMS 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. Fixed-rate bond; floating-rate bond; zero coupon bond; original issue discount (OID) bond

e. Call provision; sinking fund provision

f. Convertible bond; warrant; putable bond; income bond; indexed, or purchasing power, bond

g. Discount bond; premium bond

h. Yield to maturity (YTM); yield to call (YTC)

i. Current yield; capital gains yield; total return

j. Price risk; reinvestment risk; investment horizon; default risk; duration

k. Mortgage bond; indenture; 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, 1991. The bonds were sold at par ($1,000); had a 12% coupon; and mature in 30 years, on December 31, 2020. Coupon payments are made semiannually (on June 30 and December 31).

a. What was the YTM on January 1, 1991?

b. What was the price of the bonds on January 1, 1996, 5 years later, assuming that interest rates had fallen to 10%?

c. Find the current yield, capital gains yield, and total return on January 1, 1996, given the price as determined in part b.

d. On July 1, 2014, 6½ years before maturity, Pennington’s bonds sold for $916 .2.Whatwere 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, 2014, when the going rate of interest given its risk was 15.5%. How large a check must you write to complete the transaction? (This is a difficult question.)

ST-3 SINKING FUND The Vancouver Development Company (VDC) is planning to sell a $100 million, 10-year, 12%, semiannual 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% 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 be purchased on the open market or obtained by calling up to 5% 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% annual interest. The payments, plus accumulated interest, must total $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?