978-1259709685 Chapter 8 Case

Unlock access to all the studying documents.

View Full Document

CHAPTER 8 C-1

CHAPTER 8

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

c. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The

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

e. A deferred call would reduce the coupon rate relative to a call provision without a deferred call.

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

f. A make-whole call provision should lower the coupon rate in comparison to a call provision

with 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

CHAPTER 8 C-2

g. A positive covenant would reduce the coupon rate. The presence of positive covenants protects

bondholders by forcing the company to undertake actions that benefit bondholders. Examples

of positive covenants would be: the company must maintain audited financial statements; the

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.

i. Even though the company is not public, a conversion feature would likely lower the coupon

j. The downside of a floating rate coupon is that if interest rates rise, the company has to pay a

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: (NOTE: The text has a typo. The coupon rate on the coupon

bonds should be 7.5 percent.)

Coupon bonds to sell = $50,000,000 / $1,000 = 50,000

3. At maturity, the principal payment for the coupon bonds will be:

Coupon bond principal payment at maturity = 50,000($1,000) = $50,000,000

4. One of the main considerations is timing of the cash flows. The annual coupon payment on the

coupon bonds will be:

CHAPTER 8 C-3

Annual coupon bond payments = 50,000($1,000)(.065) = $3,250,000

Since the interest payments are tax deductible, the aftertax cash flow from the interest payments will

be:

Value of zero in one year = $1,000/1.037538 = $246.86

So, the growth on the zero coupon bond was:

Zero coupon growth = $246.86 – 229.34 = $17.52

5. If the Treasury rate is 4.80 percent, the make-whole call price in 7 years is:

6. The investor is not necessarily made whole with the make-whole call provision, but is made close to

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

7. There is no definitive answer to which type of bond the company should issue. If the intermediate

cash 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.

CHAPTER 8 C-4