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
would only be used when it is to the company’s advantage, thus the bondholders’ disadvantage.
The downside is the higher coupon rate. The company benefits by being able to refinance at a
lower rate if interest rates fall significantly, that is, enough to offset the call provision cost.
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
another bond with similar characteristics. If we compare this to a bond with a specific call price,
investors rarely receive the full market value of the future cash flows.
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
covenants is the restriction of the company’s actions.
i. Even though the company is not public, a conversion feature would likely lower the coupon rate.
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.
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:
4. One of the main considerations is timing of the cash flows. The annual coupon payment on the coupon
bonds will be:
Annual coupon bond payments = 50,000($1,000)(.075) = $3,750,000
Since the interest payments are tax deductible, the aftertax cash flow from the interest payments will
be:
5. If the Treasury rate is 4.80 percent, the make-whole call price in seven years is:
P = $37.50({1 – [1/(1 + .026)]26}/.026) + $1,000[1/(1 + .026)26]
6. The investor is not necessarily made completely 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
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.