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Chapter 5: Q12DQ (page 524)

Bonds of different risk classes will have a spread between their interest rates. Is this spread always the same? Why? (LO16-2)

Short Answer

Expert verified

The spread between interest rate and bonds of different risk classes is not always the same because the variations in the yield spread depend upon the changes in the economy.

Step by step solution

01

Spread

In finance, the term spread is used to denote the difference between two rates oryieldsassociated with stocks or bonds. The determination of spread facilitates the investors to assess the nature of the bond, whether the bond is expensive or cheap.

02

Impact on the spread

The spread between bonds of different risk classes and their interest rate is not always the same. The yield spread changes according to the variations in the economy.In addition, high rated bonds contain less risk, and low rated contain high-risk such changes in the rating also differentiate the spreads.

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Most popular questions from this chapter

Question: Barton Simpson, the chief financial officer of Broadband Inc. could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 6 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago. Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par, and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life. Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.

d. In terms of the refunding decision, how should Barton be influenced if he thinks interest rates might go down even more?

The efficient market hypothesis is interpreted in a weak form, a semi strong form, and a strong form. How can we differentiate its various forms?

Tyson Iron Works is about to go public. It currently has after-tax earnings of \(4,400,000, and 4,200,000 shares are owned by the present stockholders. The new public issue will represent 500,000 new shares. The new shares will be priced to the public at \)25 per share with a 3 percent spread on the offering price. There will also be $280,000 in out-of-pocket costs to the corporation.

e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 10 percent increase in earnings per share during the year of going public.

Explain how the bond refunding problem is similar to a capital budgeting decision. (LO16-3)

In what way is an investment banker a risk taker?

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