Chapter 16
Long-Term Debt and Lease Financing
Discussion Questions
16-1. Corporate debt has been expanding very dramatically in the last three decades.
What has been the impact on interest coverage, particularly since 1977?
16-2. What are some specific features of bond agreements?
16-3. What is the difference between a bond agreement and a bond indenture?
The bond agreement covers a limited number of items, whereas the bond
indenture is a supplement that often contains over 100 pages of complicated
16-4. Discuss the relationship between the coupon rate (original interest rate at time
of issue) on a bond and its security provisions.
16-5. Take the following list of securities and arrange them in order of their priority of
claims:
The priority of claims can be determined from Figure 16-2:
Senior secured debt
16-6. What method of “bond repayment” reduces debt and increases the amount of
common stock outstanding?
16-7. What is the purpose of serial repayments and sinking funds?
16-8. Under what circumstances would a call on a bond be exercised by a
corporation? What is the purpose of a deferred call?
A call provision may be exercised when interest rates on new securities are
16-9. Discuss the relationship between bond prices and interest rates. What impact do
changing interest rates have on the price of long-term bonds versus short-term
bonds?
Bond prices on outstanding issues and market interest rates move in opposite
16-10. What is the difference between the following yields: coupon rate, current yield,
and yield to maturity?
The different bond yield terms may be defined as follows:
Coupon rate – Stated interest rate divided by par value.
16-11. How does the bond rating affect the interest rate paid by a corporation on its
bonds?
16-12. Bonds of different risk classes will have a spread between their interest rates. Is
this spread always the same? Why?
The spread in the yield between bonds in different risk classes is not always the
16-13. Explain how the bond refunding problem is similar to a capital budgeting
decision.
The bond refunding problem is similar to a capital budgeting problem in that an
16-14. What cost of capital is generally used in evaluating a bond refunding
decision? Why?
We use the aftertax cost of new debt as the discount rate rather than the
16-15. Explain how the zero-coupon rate bond provides a return to the investor.
What are the advantages to the corporation?
The zero-coupon-rate bond is initially sold at a deep discount from par
value. The return to the investor is the difference between the investor’s
16-16. Explain how floating rate bonds can save the investor from potential
embarrassments in portfolio valuations.
Interest payments change with changing interest rates rather than with the
16-17. Discuss the advantages and disadvantages of debt.
The primary advantages of debt are:
The disadvantages are:
16-18. What is a Eurobond?
16-19. What do we mean by capitalizing lease payments?
16-20. Explain the close parallel between a capital lease and the borrow-purchase
decision from the viewpoint of both the balance sheet and the income
statement.
In both cases, we create an asset and liability on the balance sheet.
Furthermore in both cases, for income statement purposes, we amortize the
asset and write off interest (implied or actual) on the debt.
Appendix
16A-1. What is the difference between technical insolvency and bankruptcy?
Technical insolvency refers to the circumstances where a firm is unable to pay
its bills as they come due. A firm may be technically insolvent even though it
16A-2. What are the four types of out-of-court settlements? Briefly describe each.
16A-3. What is the difference between an internal reorganization and an external
reorganization under formal bankruptcy procedures?
An internal reorganization calls for an evaluation and restricting of the current
16A-4. What are the first three priority items under liquidation in bankruptcy?
Chapter 16
Problems
(Assume the par value of the bonds in the following problems is $1,000 unless otherwise
specified.)
1. Bond yields (LO16-2) The Pioneer Petroleum Corporation has a bond outstanding with an
$85 annual interest payment, a market price of $800, and a maturity date in five years. Find
the following:
a. The coupon rate.
b. The current rate.
c. The yield to maturity.
16-1. Solution:
The Pioneer Petroleum Company
Calculator Solution:
(c)
N I/Y PV PMT FV
Answer: 14.38
2. Bond yields (LO16-2) Preston Corporation has a bond outstanding with an $80 annual
interest payment, a market price of $1,250, and a maturity date in 10 years. Assume the par
value of the bonds is $1,000.
Find the following:
16-2. Solution:
Preston Corporation
(c)
N I/Y PV PMT FV
Answer: 4.79
3. Bond yields (LO16-2) Harold Reese must choose between two bonds:
Bond X pays $95 annual interest and has a market value of $900. It has 10 years
to maturity.
Bond Z pays $95 annual interest and has a market value of $920. It has two years
to maturity.
a. Compute the current yield on both bonds.
b. Which bond should he select based on your answer to part a?
c. A drawback of current yield is that it does not consider the total life of the bond. For
example, the yield to maturity on Bond X is 11.21 percent. What is
the yield to maturity on Bond Z?
d. Has your answer changed between parts b and c of this question?
16-3. Solution:
a. Bond X
Bond Z
b. He should select Bond X. It has a higher current yield.
(c)
N I/Y PV PMT FV
Answer: 14.38
d. Yes. Bond Z has the higher yield to maturity. This is because
4. Bond yields (LO16-2) An investor must choose between two bonds:
Bond A pays $72 annual interest and has a market value of $925. It has 10 years to
maturity. Bond B pays $62 annual interest and has a market value of $910. It has two years
to maturity. Assume the par value of the bonds is $1,000.
a. Compute the current yield on both bonds.
b. Which bond should she select based on your answer to part a?
c. A drawback of current yield is that it does not consider the total life of the bond. For
example, the yield to maturity on Bond A is 8.33 percent. What is the yield to maturity
on Bond B?
d. Has your answer changed between parts b and c of this question in terms of which
bond to select?
16-4. Solution:
a. Bond A
Bond B
b. Bond A. It has a higher current yield.
(c)
N I/Y PV PMT FV
Answer: 11.49%
d. Yes. Bond B now has the higher yield to maturity. This is because
5. Secured vs. unsecured debt (LO16-1) Match the yield to maturity in column 2 with the
security provisions (or lack thereof) in column 1. Higher returns tend to go with greater
risk.
(1) (2)
Security Provision Yield to Maturity
a. Debenture a. 6.85%
b. Secured debt b. 8.20%
c. Subordinated debenture c. 7.76%
16-5. Solution:
Security Provision Yield to Maturity
6. Bond value (LO16-2) The Florida Investment Fund buys 58 bonds of the Gator
Corporation through a broker. The bonds pay 10 percent annual interest. The yield to
maturity (market rate of interest) is 12 percent. The bonds have a 10-year maturity.
Using an assumption of semiannual interest payments:
a. Compute the price of a bond (refer to “Semiannual Interest and Bond Prices” in
Chapter 10 for review if necessary).
b. Compute the total value of the 58 bonds.