Question

Debtholders have a "residual claim" on assets. In other words, out of the company's assets, first the common stockholders are paid and the residual is paid to the debtholders.

True

False

An inflation linked bond (floating rate bond) matures in 2 years and has and a face value of $1,000 and a coupon rate of 10%. Inflation rate over the first year is 1% and the inflation rate over the second year is 3%. What is the amount that the investor will receive at the end of the first (1st) year?

		$100
		$1100
		$101
		$1,111

Answer 1

Debt holder's have right of first lien over the assets of a compoany in the event of a liquadation of the comoany and therefore debtholders are entitled to be paid first and then after the satisfaction of Debt holders the equity shareholders will be paid. There the statement mentioned is flase as debt holders are paid first and then equity share holders have a residual claim on assets.

Given that the bond has a maturity of 2 years and the coupon rate is a floating rate adjusted for inflation, therefore our reference inflation rate or rather base inflation rate is 1%. For year 1 the coupon rate is 10% and once the inflation rate rises to 2% the floating coupon rate becomes 10 % + (1% increase in inflation) = 11%.

Therefore the coupon rate for year 1 is 10 % (assuming the base/ Referencne inflation rate of 1%)

Coupon amount = Par value of the bond x Coupon Rate

Coupon amount at the end of 1st year = $ 1000 x 10% = $ 100