Risk and cost of capital of convertible bonds and straight bonds

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Chapter 20, Problem 7Q

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To discuss: Risk and cost of capital of convertible bonds and straight bonds

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Suppose a company simultaneously issues $50 million of convertible bonds with a couponrate of 9% and $50 million of nonconvertible bonds with a coupon rate of 12%. Bothbonds have the same maturity. Because the convertible issue has the lower coupon rate, isit less risky than the nonconvertible bond? Would you regard the cost of capital as beinglower on the convertible than on the nonconvertible bond? Explain. (Hint: Althoughit might appear at first glance that the convertible’s cost of capital is lower, this is notnecessarily the case, because the interest rate on the convertible understates its true cost.Think about this.)

Which of the following observations is the most accurate? 34.A callable bond will have a lower required rate of return than a noncallable bond, assuming all other factors remain stable.b. If all other factors were equal, a company would choose to issue noncallable bonds over callable bonds.c. From the perspective of a traditional investor, reinvestment rate risk is higher than interest rate risk.d. If a 10-year, $1,000 par, zero coupon bond was sold at a price that offered buyers a 10% rate of return, and interest rates fell to the point where kd = YTM = 5%, we might be certain that the bond would sell for more than its $1,000 par value.e. If a 10-year, $1,000 par, zero coupon bond was sold at a price that provided borrowers with a 10% rate of return, and interest rates subsequently fell to the point where kd = YTM = 5%, we might be certain that the bond would sell at a discount below its $1,000 par value.

Which statement is false? O A. As the term of a bond approaches zero, the price approaches kar. O B. For corporate and government bonds, the coupon payments amortize the princi OC. Overall, bond prices are less volatile than stock prices. O D. The coupon on a bond is expressed as a percentage of face value. O E. Corporate bonds can be bought and sold in the secondary market. Reset Selection