Term Paper On: Case Study with Question & Answer

Submitted By: Mazharul Karim

Id No: 51840042
Department of Banking and Insurance
University of Dhaka

Question

If the economy continues to be strong, Carson Company may need to increase its production
capacity by about 50 percent over the next few years to satisfy demand. It would need financing
to expand and accommodate the increase in production. Recall that the yield curve is currently
upward sloping. Also recall that Carson is concerned about a possible slowing of the economy
because of potential Fed actions to reduce inflation. It needs funding to cover payments for
supplies. It is also considering issuing stock or bonds to raise funds in the next year.
a. Assume that Carson has two choices to satisfy the increased demand for its products. It could
increase production by 10 percent with its existing facilities by obtaining short-term financing to
cover the extra production expense and then using a portion of the revenue received to finance
this level of production in the future. Alternatively, it could issue bonds and use the proceeds to
buy a larger facility that would allow for 50 percent more capacity. Which alternative should
Carson select?

b. Carson currently has a large amount of debt, and its assets have already been pledged to back
up its existing debt. It does not have additional collateral. At this time, the credit risk premium it
would pay is similar in the short-term and long-term debt markets. Does this imply that the cost
of financing is the same in both markets?

c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson
decide not to include a call provision on the bonds?

d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a
private placement of bonds? What type of investor might be interested in participating in a
private placement? Do you think Carson could offer the same yield on a private placement as it
could on a public placement? Explain.

e. Financial institutions such as insurance companies and pension funds commonly purchase
bonds. Explain the flow of funds that runs through these financial institutions and ultimately
reaches corporations that issue bonds such as Carson Company.
 Summary

Carson company need to increase its overall production to meets the customers’ demands in this
growing economy. In that case it need more financing to raise the overall production at 50
percent over the next few years. Before increasing the production carson company need to look
in the yield curve which is currently in upward position also the economy can be slowing down
due to potential fed action regarding reducing the inflation rate. Even though it has to consider
the funding which will cover the payment for supplies so it has to considering issuing stock or
bond to meet the funds by next year.

Answer the question of (a)

Answer: Carson Company is concerned about a possible slowing of the economy because of
Fed’s action to reduce inflation. If inflation reduces, the interest rates would fall. Therefore,
issuing long term bonds for financing 50 percentage capacities is not a good choice as it would
result in extra interest payment periodically as compared to market rates.

It could instead increase production by 10% with its existing facilities and obtain short term
financing to cover extra production expense and then use a portion of the revenue received to
finance this level of production in the future.

Answer the question of (b)

The cost of financing is not the same for a debt pledged by collateral and short and long term
debt securities when the risk premium is the same.

So this can avoid long term debt for now. But if demand does not increase as it anticipated then
the short term debt can be used when matured.

Answer the question of (c)

Carson should consider call provision as through this Carson could call back its bonds before
maturity and can reduce its debt also if in future the interest rate decrease it can call back the
existing bond and issues new bonds at lower interest rate and thus can reduce its funding cost.

The reason Carson decide not to include call provision may be higher yield. Because if Carson
add call provision it has to pay higher yield to compensate the bond holders as the bond
holders will lose interest earning if the bond is call back before maturity.

Answer the question of (d)

Carson may consider private placement for borrowing relatively small amount of fund. For
private placement it does not have to be registered with SEC. They may hire securities firm to
place bonds because such firms are able to identify institutional investors that may be
interested in private placement. The institutional investors that commonly purchase a private
placement include insurance companies, pension funds, and bond mutual funds. They do not
have a secondary market and tend to be purchased for a longer period of time.

The yield on private placement is more than public offering due to less floatation cost and
flexibility offered to purchaser

Answer the question of (e)

Companies that plan to issue bonds through public borrowing hires an investment bank to
underwrite to bonds.

i) The underwriter determines the price and the appropriate size of the offering by assessing the
market conditions.
ii) The goal of the offering is set and appropriate price for the offering that is not only high
enough to satisfy the issuer, but also low enough so that the entire bond offering can be placed.

iii) The issuer registers itself with the SEC and submits a prospectus that discloses the size of
the offering, its updated financial condition and its planned use of the funds.

iv) Meanwhile, the underwriter invites the investment banks to join a syndicate to help place
bonds in the market by distributing the prospectus.

v) When the SEC approves the issue the underwriting syndicate places the bonds. A portion of
the registered bonds can be deferred up to two years if the issuer does not want to place the
entire offering at once.

The underwriters try to place the bonds with institutional investors such as insurance
companies and pension funds because they are likely to purchase large portion of offering.
Thus, money flows from such institutions to underwriters and as per terms of their agreement
(before or after deducting their commission) they pay the amount to the issuer.