Question

1. Assuming all else is constant, which of the following statements is CORRECT?

a. Other things held constant, a 20-year zero coupon bond has more reinvestment risk than a 20-year coupon bond.

b. Other things held constant, price sensitivity as measured by the percentage change in price due to a given change in the required rate of return decreases as a bond's maturity increases.

c. Other things held constant, for any given maturity, a 1.0 percentage point decrease in the market interest rate would cause a smaller dollar capital gain than the capital loss stemming from a 1.0 percentage point increase in the interest rate.

d. For a bond of any maturity, a 1.0 percentage point increase in the market interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from a 1.0 percentage point decrease in the interest rate.

e. From a corporate borrower's point of view, interest paid on bonds is not tax-deductible.

2. Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 45.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

a. –0.42%

b. –0.44%

c. –0.30%

d. –0.36%

e. –0.35%

Answer 1

1. Option d - For a bond of any maturity, a 1.0 percentage point increase in the market interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from a 1.0 percentage point decrease in the interest rate.

2. Option e: -0.35%