Question

Company 1 and Company 2 are comparable companies. Bond 1 was issued by Company 1 and Bond 2 was issued by Company 2. Bond 1 and Bond 2 both currently trade at par and are yielding 5.0%. Bond 1 is callable at $1050 while Bond 2 is puttable at $950. $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 S- Bond Price (Y-Axis) vs. Yield to Maturity (X-Axis) 79.75 1,270.68 1,194.61 $1,12.o7 022 27 31 884 3 1,171.9 1,000.00 93 587834 5841 75 $806.9 00% 1.0% 2.0% 3.0% 40% 5056 6.0% 7.0% 8.0% 9.0% 10.0% BONDBOND 2 12. Bond I's YTM instantaneously falls to 4.0% while Bond 2's YTM instantaneously increases to 6.0%. Which of the following is statements is (are) most likely TRUE: I. Bond 1's credit rating was just downgraded by a credit rating agency Il. Bond 2's credit rating was just upgraded by a credit rating agency Ill. Company1 will buy the bond back from the creditors IV. Company 1's creditors will buy the bond back from the company V. Company 2's creditors will sell the bond back to the company E. IV 13. Assume that ROE is the only factor which impacts a stock's price; the higher a stock's ROE, the better the stock will perform. You are considering buying only one of the following: a defensive company with low debt, a defensive company with high debt, a cyclical company with low debt, or a cyclical company with high debt. Given the position in the business cycle, which statement is most accurate? A. When entering a recession, buy a cyclical company with low leverage B. When entering a recession, buy a defensive company with low leveroge C. During the expansion phase of a business cycle, buy a defensive company with high leveroge D. During the expansion phase of a business cycle, buy a cyclical company with low leverage E. During the expansion phase of a business cycle, buy a cyclical company with high leverage

Answer 1

In the given case, bond 1 is callable and bond 2 is putable. YTM of bond 1 instantaneously falls and that of bond 2 instantaneously increases because company 1 will buy the bond from the creditors and company 2's creditors will sell the bond back to the company.

Hence, the correct answer is option (D).

Answer to question 13

During expansion phase, a cyclical company with low leverage would be the best as it will perform really well taking full advantage of the economic condition and with that it would also have very high ROE as the debt would be low. Hence, option (D) is preferable