 Answers to Chapter 6 Critical Thinking Questions

1. A bond is like a loan because of the structure of the payments. The bond pays a regular coupon
payment, which closely resembles an interest payment on a loan. At the maturity of the bond, the par
value is paid, which is like repaying the principal of the loan. Any missed payment on a bond is
considered a default on the loan, similar to defaulting on a loan.

2. Like any investment, a bond requires an initial cost (the price of the bond) and results in future cash
flows (coupon payments and par value) to the investor. An investor will discount the future cash
flows to ensure that the initial investment earns an adequate rate of return. The return is in the form
of future coupon payments and par value payment that have a present value at least as great as the
price of the bond.

3. The internal rate of return is the single discount rate that implies that the PV of the benefits of an
investment is equal to the PV of the costs of the investment. The yield to maturity is the internal rate
of return for a bond. The yield to maturity is the single discount rate that implies that the PV of the
bond’s cash flows is equal to its price.

4. The price of the bond determines the yield to maturity. The price of the bond is determined by the
interest rate yield curve for the bond. The yield to maturity is just the single discount rate that implies
the observed market price of the bond.

5. When the coupon rate is equal to the yield of maturity, the price of the bond equals the par value.
Thus, when the yield increases (while holding the coupon rate constant), the price of the bond must
decrease and, therefore, is priced below the par value (at a discount).

6. Bond prices and interest rates are inversely related. As interest rates rise, the PV of the bond’s cash
flows decreases, causing a decrease in the price of the bond. As interest rates fall, the PV of the
bond’s future cash flows increase, resulting in an increase in the price of the bond.

7. Longer-term bonds are more sensitive to interest rate changes because of the compounding of
interest. Compounding effects increase as time periods get longer, thus longer term cash flows are
affected more than shorter term cash flows.

8. The yield to maturity on a corporate bond reflects the single discount rate that implies the price given
the promised cash flows of the bond. However, corporate bonds have the potential to default, thus the
expected cash flows from the bond are lower than the promised cash flows. (To the extent that the
probability of default can be determined, the expected cash flows reflect the probability of default.)
Thus, the expected return is lower than the yield to maturity for corporate bonds.