Laurinburg Precision Engineering

Oliver MacKinnon and Beacham McDougald founded Laurinburg Precision Engineering in 1997
to manufacture precision injection-molded parts for use in medical devices. After an uncertain start-
up period, the company won contracts from several different manufacturers. Using special
machinery and expertise in injection molding of specialty plastics, the company prospered.
In early 2004, the company was experiencing a cash crisis caused by rapid gr owth and the desire
to extend capabilities through the acquisition of new molding machines. The partners had no
additional capital to finance the expansions, and they were reluctant to sell equity to anyone else. A
bank loan was considered, but financial projections indicated the loan could not be paid down for
almost five years. Because of prevailing interest rates, local banks were unwilling to make a loan
commitment of that duration.

Their local bank had introduced MacKinnon and McDougald to a small investment banking firm
in Charlotte, North Carolina. After a consultation with MacKinnon and McDougald, Sheila Cox, a
partner in the investment banking firm, suggested a $1 million bond issue with a term of five years.
The bond issue would be secured by the new machinery and placed with private investors. Cox told
MacKinnon and McDougald that she expected the bonds would have to be sold to yield almost 10%
interest. She proposed setting the interest rate on the bonds at 10%, with semiannual interest
payments and the principal due at the end of the fifth year, and she prepared a schedule of the
interest and principal repayments that would be due if the bonds were sold to yield 10% interest
exactly (see Exhibit 1).

Although the proposal seemed to be a reasonable solution to the problem facing MacKinnon and
McDougald, both were worried about the semiannual interest payments in the early years. They
expected operating cash flows would remain tight as Laurinburg Precision Engineering continued to
grow. When they expressed this concern to Cox by telephone, she suggested a second alternative.
Laurinburg Precision Engineering could issue zero-coupon bonds at the same interest rate and terms.
On these bonds no interest payments would be made during the five years the bonds would be
outstanding, and all interest and principal would be due on January 15, 2009, when the bonds
matured. The principal amount of the zero-coupon bonds would be greater than that of the 10%
bonds, but Laurinburg would have five years to prepare to pay interest and principal from either
operations or additional financing.