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East Coast Yacht's Expansion Plans by taipeigooch | studymode.com

Corporate Finance: Chapter 5: Financing East Coast Yacht’s Expansion Plans with a Bond 1.If the company benefits from the provision of the bond, then the coupon rate will be higher. If the bondholder’s benefit, then the bond will have lower coupon rate. a.Bond’s with collateral will have lower coupon rate as bondholders have claim on collateral no matter what. It provides an asset which lowers default risk. Downside to company is that this collateral cannot be sold as an asset and needs to maintain it. b.The more senior the bond, the lower the coupon rate. c.A sinking fund reduces coupon rate because it provides a kind of future guarantee to bondholders. The company must make payments into the sinking fund or default so it must have positive cash flows. d.A call provision would cause an increase in coupon rate. It must be used in the company’s advantage and bondholder’s disadvantage. The company can refinance the bond if interest rates drop and thus gain an advantage. e.A deferred call would reduce the coupon rate in comparison to the above case. The bond will still have a higher coupon rate, but it offers bondholders some kind of protection. Company cannot call the bond during the protection period f.This would lower the whole coupon rate. Repays the bondholder full future cash flows, but rarely receive full market value. g.A positive covenant would reduce coupon rate. It protects bondholders by forcing company’s to benefit bondholders. h.A negative covenant would reduce coupon rate in turn. i.A conversion feature would lower coupon rate. Bondholders would benefit if company goes public, but company would be selling equity at discounted price. j.If interest rates rise, then company need to pay higher interest rate, if rates fall, then company benefits. 2. Coupon bonds to sell = $30,000,000 / $1,000 = 30,000 The price of the 20-year, zero coupon bond when it is issued will be:

Zero coupon price = $1,000 / 1.0820 = $214.55 So, the number of zero coupon bonds the company will need to sell is: Zero coupon bonds to sell = $30,000,000 / $214.55 = 139,827 3. Coupon bond principal payment at maturity = 30,000($1,000) = $30,000,000 The principal payment for the zero coupon bonds at maturity will be: Zero coupon bond payment at maturity = 139,827($1,000) = $139,827,000 4. Annual coupon bond payments = 30,000($1,000)(.08) = $2,400,000 Since the interest payments are tax deductible, the aftertax cash flow from the interest payments will be: Aftertax coupon payments = $2,400,000(1 – .35) = $1,560,000 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 = $1,000/1.0819 = $231.71 5. P = $40({1 – [1/(1 + .03)]26 } / .03) + $1,000[1 / (1 + .03)26] P = $1,178.77 And, if the Treasury rate is 9.10 percent, the make whole call price in 7 years is: P = $40({1 – [1/(1 + .0475)]26 } / .0475) + $1,000[1 / (1 + .0475)26] P = $889.35 So, the growth on the zero coupon bond was: Zero coupon growth = $231.71 – 214.55 = $17.26 This increase in value is tax deductible, so it reduces taxes even though there is no cash flow for interest payments. So, there is a positive cash flow created next year in the amount of:

Zero cash flow = 139,827($17.26)(.35) = $839,989.70 This cash flow will increase each year since the value of the zero coupon bond will increase by a greater dollar amount each year. 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 0.5 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. This means the investor is more than made whole. If the bond is called late in its life, the spread is too high. This means the interest rate used to calculate the present value of the cash flows is too high, which results in a lower present value. Thus, the bondholder is made less than whole. In practical terms, this difference is likely to be small, and is will almost always result in a higher price paid to the bondholder when compared to a traditional call feature. 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. As for the type of call provision, a make whole call provision is generally better for bondholders, therefore the coupon rate of the bond will likely be lower to sell the bond at par value. Again, there is a tradeoff.