A sinking fund can be set up in one of two ways:

• The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity.

• The trustee uses the annual payments to retire a portion of the issue each year, calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper.

What are the advantages and disadvantages of each procedure from the viewpoint of the firm and the bondholders?

Stock A has an expected return of 7%, a standard deviation of expected returns of 35%, a correlation coefficient with the market of 0.3, and a beta coefficient of 0.5. Stock B has an expected return of 12%, a standard deviation of returns of 10%, a 0.7 correlation with the market, and a beta coefficient of 1.0. Which security is riskier? Why?

Is it possible to construct a portfolio of real-world stocks that has a required return equal to the risk-free rate? Explain.

Why is a call provision advantageous to a bond issuer? When would the issuer be likely to initiate a refunding call?

“Short-term interest rates are more volatile than long-term interest rates, so short-term bond prices are more sensitive to interest rate changes than are long-term bond prices.” Is this statement true or false? Explain.

The Vancouver Development Company (VDC) is planning to sell a 100 million dollars, 10-year, 12 percent, semiannual payment bond issue. Provisions for a sinking fund to retire the issue over its life will be included in the indenture. Sinking fund payments will be made at the end of each year, and each payment must be sufficient to retire 10 percent of the original amount of the issue. The last sinking fund payment will retire the last of the bonds. The bonds to be retired each period can be purchased on the open market or obtained by calling up to 5 percent of the original issue at par, at VDC's option.

a. How large must each sinking fund payment be if the company (1) uses the option to call bonds at par or (2) decides to buy bonds on the open market? For part (2), you can only answer in words.

b. What will happen to debt service requirements per year associated with this issue over its 10 -year life?

c. Now consider an alternative plan where VDC sets up its sinking fund so that equal annual amounts are paid into a sinking fund trust held by a bank, with the proceeds being used to buy government bonds that are expected to pay 7 percent annual interest. The payments, plus accumulated interest, must total 100 million dollars at the end of 10 years, when the proceeds will be used to retire the issue. How large must the annual sinking fund payments be? Is this amount known with certainty, or might it be higher or lower?

d. What are the annual cash requirements for covering bond service costs under the trusteeship arrangement described in part c? (Note: Interest must be paid on Vancouver's outstanding bonds but not on bonds that have been retired.) Assume level interest rates for purposes of answering this question.

e. What would have to happen to interest rates to cause the company to buy bonds on the open market rather than call them under the plan where some bonds are retired each year?

A life insurance policy is a financial asset, with the premiums paid representing the investment’s cost. a. How would you calculate the expected return on a 1-year life insurance policy? b. Suppose the owner of a life insurance policy has no other financial assets—the person’s only other asset is “human capital,” or earnings capacity.What is the correlation coefficient between the return on the insurance policy and the return on the human capital? c. Life insurance companies must pay administrative costs and sales representatives’ commissions; hence, the expected rate of return on insurance premiums is generally low or even negative. Use portfolio concepts to explain why people buy life insurance in spite of low expected returns.

Suppose the population of Area Y is relatively young, and the population of Area O is relatively old, but everything else about the two areas is the same. a. Would interest rates likely be the same or different in the two areas? Explain. b. Would a trend toward nationwide branching by banks and the development of nationwide diversified financial corporations affect your answer to part a? Explain.

Thornwood Tile had the following items that require adjusting entries at the end of the year.

a. Thornwood pays payroll of $180,000 every other Friday for a 2-week period. This year the last payday is Friday, December 26. (Note: The work week is Monday through Friday.)

b. Thornwood purchased$350,000 of tile on June 1 with a note payable requiring 12% interest. The interest and principal on this note are due within 1 year. As of December 31, Thornwood had not made any principal or interest payments.

c. Thornwood’s earned income is $900,000 for the year for tax purposes. Its effective tax rate is 30%. These taxes must be paid by April 15 of next year.

Required:

Prepare the adjusting journal entries to record these transactions at the end of the current year.

Suppose you are considering taking consumer loan from bank for one year. Usually, for short-term loans, the bank offers 12 percent interest that compounds annually. Your credit application has been viewed by a few banks and two of them replied; Bank ALFA offers you a loan at 12 percent annual rate-interest payment by the end of year, and Bank BETA offers a loan with the same annual interest rate, but interest payment is 3 percent by the end of each quarter. Which loan do you prefer? Why?

Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain.

The Pennington Corporation issued a new series of bonds on January $1 , 1991$. The bonds were sold at par $(\$ 1,000)$; had a $12 \%$ coupon; and mature in $30$ years, on December $31, 2020.$ Coupon payments are made semiannually (on June $30$ and December $31$).

a. What was the YTM on January $1, 1991$?

b. What was the price of the bonds on January $1, 1996$, $5$ years later, assuming that interest rates had fallen to $10 \%$ ?

c. Find the current yield, capital gains yield, and total return on January $1, 1996$, given the price as determined in part above.

d. On July $1, 2014$, $6 ^{1/2}$ years before maturity, Pennington's bonds sold for $\$ 916.42$. What were the YTM, the current yield, the capital gains yield, and the total return at that time?

e. Now assume that you plan to purchase an outstanding Pennington bond on March $1 , 2014$, when the going rate of interest given its risk was $15.5 \%$. How large a check must you write to complete the transaction? (This is a difficult question.)

Pennington Corporation issued 5-year, 8.6% bonds with a total face value of $700,000 on January 1, 2021, for$680,000. The bonds pay interest on June 30 and December 31 of each year.

Required:

Prepare the entries to recognize the bond issuance and the interest payments made on June 30, 2021, and December 31, 2021.

The probability distribution of a less risky expected return is more peaked than that of a riskier return. What shape would the probability distribution be for (a) completely certain returns and (b) completely uncertain returns?