Chapter 2 Practice Question Answers
1. Answer: B. When a company issues a set of new bonds and puts the proceeds in an escrow fund to pay off a set of older bonds, it is called pre-refunding or advance refunding. The pre-refunded bonds are typically AAA rated. The funds that will be used in advance refunding must be kept in an escrow account. The pre-refunded bonds will no longer count as debt on the issuer’s balance sheet, and when this occurs, the bonds are considered defeased.
2. Answer: D. A corporation would be most likely to call an issue of bonds in which it has to pay the highest interest payments. It would also prefer to call a set of bonds that it has to pay back only the par value rather than the par value plus a premium.
3. Answer: A. Basis points refer to one-hundredths of a percent on a yield quote. So 60 basis points would be equivalent to 0.6%. On a $1,000 par bond, it would be equivalent to $6 (0.6% x $1,000).
4. Answer: C. In order for a bond to be trading at parity, it needs to be trading at the conversion value. To calculate this value, first find the conversion ratio by dividing the conversion price into $1,000 ($1,000 / $25 = 40 shares per bond). Then take the ratio times the share price, which is equal to $1,800 ($45 x 40). Parity is the price of the bond that is equal to the bond’s value if converted to common stock.
5. Answer: A. A sinking fund redemption requires the issuer to set money aside regularly in a reserve account for the redemption of the bonds before maturity.
6. Answer: A. A bond refunding is the replacement of existing bonds with new “refunding” bonds. The issuer of refunding bonds often seeks to lower its interest payments by paying off its previously issued (refunded) bonds with newly issued bonds that pay interest at a lower rate. Another reason to refund existing bonds may be to release the issuer from legal covenants or restrictions in the original indenture.
7. A