CHAPTER 5 C-1
CHAPTER 5
FINANCING EAST COAST YACHT’S
EXPANSION PLANS WITH A BOND
ISSUE
1. A rule of thumb with bond provisions is to determine who the provisions benefit. If the company
benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have
a lower coupon rate.
a. A bond with collateral will have a lower coupon rate. Bondholders have the claim on the
collateral, even in bankruptcy. Collateral provides an asset that bondholders can claim, which
b. The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in
bankruptcy proceedings before subordinated bonds receive any payment. A potential problem
may arise in that the bond covenant may restrict the company from issuing any future bonds
c. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The
problem with a sinking fund is that the company must make the interim payments into a sinking
fund or face default. This means the company must be able to generate these cash flows.
d. A provision with a specific call date and prices would increase the coupon rate. The call provision
would only be used when it is to the company’s advantage, thus the bondholder’s disadvantage.
The downside is the higher coupon rate. The company benefits by being able to refinance at a
The bond will still have a higher rate relative to a plain vanilla bond. The deferred call means
that the company cannot call the bond for a specified period. This offers the bondholders
protection for this period. The disadvantage of a deferred call is that the company cannot call the
bond during the call protection period. Interest rates could potentially fall to the point where it
specific dates since the make whole call repays the bondholder the present value of the future
cash flows. However, a make whole call provision should not affect the coupon rate in
comparison to a plain vanilla bond. Since the bondholders are made whole, they should be
indifferent between a plain vanilla bond and a make whole bond. If a bond with a make whole
provision is called, bondholders receive the market value of the bond, which they can reinvest in
bondholders by forcing the company to undertake actions that benefit bondholders. Examples of
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positive covenants would be: the company must maintain audited financial statements; the
company must maintain a minimum specified level of working capital or a minimum specified
current ratio; the company must maintain any collateral in good working order. The negative side
h. A negative covenant would reduce the coupon rate. The presence of negative covenants protects
bondholders from actions by the company that would harm the bondholders. Remember, the goal
of a corporation is to maximize shareholder wealth. This says nothing about bondholders.
Examples of negative covenants would be: the company cannot increase dividends, or at least
increase beyond a specified level; the company cannot issue new bonds senior to the current bond
issue; the company cannot sell any collateral. The downside of negative covenants is the
The conversion feature would permit bondholders to benefit if the company does well and also
goes public. The downside is that the company may be selling equity at a discounted price.
higher interest rate. However, if interest rates fall, the company pays a lower interest rate.
2. Since the coupon bonds will have a coupon rate equal to the YTM, they will sell at par. So, the number
of coupon bonds to sell will be:
Coupon bonds to sell = $45,000,000/$1,000 = 45,000
The price of the 30-year, zero coupon bond when it is issued will be:
Zero coupon price = $1,000/1.027560 = $196.38
Coupon bond principal payment at maturity = 45,000($1,000) = $45,000,000
The principal payment for the zero coupon bonds at maturity will be:
Zero coupon bond payment at maturity = 229,151($1,000) = $229,151,311
bonds will be:
Annual coupon bond payments = 45,000($1,000)(.055) = $2,475,000
Since the interest payments are tax deductible, the aftertax cash flow from the interest payments will
be:
Aftertax coupon payments = $2,475,000(1 – .35) = $1,608,750
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Even though interest payments are not actually made each year, the implied interest on the zero coupon
bonds is tax deductible. The value of the zero coupon bonds next year will be:
Value of zero in one year = $1,000/1.027558 = $207.33
So, the growth on the zero coupon bond was:
Zero coupon growth = $207.33 – 196.38 = $10.95
interest payments. So, there is a positive cash flow created next year in the amount of:
Zero cash flow = 229,151($10.95)(.35) = $878,160.94
greater dollar amount each year.
5. If the Treasury rate is 4.80 percent, the make whole call price in seven years is:
P = $27.50({1 – [1/(1 + .026)46]}/.026) + $1,000[1/(1 + .026)46]
P = $1,039.98
P = $27.50({1 – [1/(1 + .033)46]}/.033) + $1,000[1/(1 + .033)46]
P = $870.76
whole. Assume a company issues a bond with a make whole call of the Treasury rate plus .5 percent.
Further assume this is the correct average spread for the company’s bond over the life of the bond.
Although the spread is correct on average, it is not correct at every specific time. The spread over the
Treasury rate varies over the life of the bond, and is higher when the bond has a longer time to maturity.
To see this, consider, at the extreme, the spread for any bond above the Treasury yield at maturity is
zero. So, if the bond is called early in its life, the spread above the Treasury is likely to be too low.
flows for the coupon payments will be difficult, a zero coupon bond is likely to be the best solution.
However, the zero coupon bond will require a larger payment at maturity.