Chapter 8

Financing East Coast Yachts Expansion Plans with a Bond Issue

Input area:

Years to maturity 20
Required return 7.50%
Amount needed $ 40,000,000
Face value $ 1,000

Coupon rate 7.50%

Payment 75.00
Tax rate 35%

Year bond is called 7

Spread above Treasury 0.40%
Treasury rate at call 5.60%
Treasury rate at call 9.10%

Output area:

1) A rule of thumb with bond provisions is to determine who the provisions benefit. If the company benefits, the b
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 ban
claim, which lowers their risk in default. The downside of collateral is that the company generally cannot sell t
keep the asset in good working order.
b The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy proceedin
potential problem may arise in that the bond covenant may restrict the company from issuing any future bonds
c A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The problem with a
payments into a sinking fund or face default. This means the company must be able to generate these cash flow
d A provision with a specific call date and prices would increase the coupon rate. The call provision would only b
bondholder’s disadvantage. The downside is the higher coupon rate. The company benefits by being able to ref
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
deferred call means that the company cannot call the bond for a specified period. This offers the bondholders p
is that the company cannot call the bond during the call protection period. Interest rates could potentially fall to
call the bond, yet the company is unable to do so.
f A make-whole call provision should lower the coupon rate in comparison to a call provision with specific dates
present value of the future cash flows. However, a make-whole call provision should not affect the coupon rate
bondholders are made whole, they should be indifferent between a plain vanilla bond and a make-whole bond.
bondholders receive the market value of the bond, which they can reinvest in another bond with similar charact
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
bondholders. Examples of positive covenants would be: the company must maintain audited financial statemen
working capital or a minimum specified current ratio; the company must maintain any collateral in good worki
company is restricted in its actions. The positive covenant may force the company into actions in the future tha
h A negative covenant would reduce the coupon rate. The presence of negative covenants protects bondholders fr
bondholders. Remember, the goal of a corporation is to maximize shareholder wealth. This says nothing about
company cannot increase dividends, or at least increase beyond a specified level; the company cannot issue new
sell any collateral. The downside of negative 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 conversio
company does well and also goes public. The downside is that the company may be selling equity at a discount
j The downside of a floating rate coupon is that if interest rates rise, the company has to pay a higher interest rate
interest rate.

2) Price of coupon bond $1,000.00

# of coupon bonds needed 40,000

Price of zero coupon bond $235.41

# of zeroes needed 169,916

3) Repayment of coupon bonds $ 40,000,000

Repayment of zeroes $ 169,916,000

4) Year 1 interest payments:

Pretax coupon payment $ 3,000,000
Aftertax coupon payment $ 1,950,000 Cash outflow

Value of zero in one year $253.07

Zero coupon growth $ 17.66
Zero coupon bond $ (1,050,199.30) Cash inflow

During the life of a bond, the zero generates cash inflows to the firm
in the form of the interest tax shield of debt.

5) Make whole price $1,132.79 MENGGUNAKAN RUMUS PRESENT

DI EXCEL
 Make whole price $854.18

6)
The investor is not necessarily made whole with the make-whole call provision, but is made close to whole. As
the Treasury rate plus 0.5 percent. Further assume this is the correct average spread for the company’s bond ov
average, it is not correct at every specific time. The spread over the Treasury rate varies over the life of the bon
To see this, consider, at the extreme, the spread for any bond above the Treasury yield at maturity is zero. So, i
Treasury is likely to be too low. This means the investor is more than made whole. If the bond is called late in i
used to calculate the present value of the cash flows is too high, which results in a lower present value. Thus, th
this difference is likely to be small, and it will almost always result in a higher price paid to the bondholder wh

7) There is no definitive answer to which type of bond the company should issue. If the intermediate cash flows fo
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
at par value. Again, there is a tradeoff.
 a Bond Issue

efit. If the company benefits, the bond will have a higher coupon rate. If the bondholders

aim on the collateral, even in bankruptcy. Collateral provides an asset that bondholders can
e company generally cannot sell the asset used as collateral, and they will generally have to

payment in bankruptcy proceedings before subordinated bonds receive any payment. A

ny from issuing any future bonds senior to the current bonds.
bondholders. The problem with a sinking fund is that the company must make the interim
e able to generate these cash flows.
e. The call provision would only be used when it is to the company’s advantage, thus the
pany benefits by being able to refinance at a lower rate if interest rates fall significantly, that

out a deferred call. The bond will still have a higher rate relative to a plain vanilla bond. The
od. This offers the bondholders protection for this period. The disadvantage of a deferred call
erest rates could potentially fall to the point where it would be beneficial for the company to
 call provision with specific dates since the make-whole call repays the bondholder the
should not affect the coupon rate in comparison to a plain vanilla bond. Since the
la bond and a make-whole bond. If a bond with a make-whole provision is called,
another bond with similar characteristics. If we compare this to a bond with a specific call

ovenants protects bondholders by forcing the company to undertake actions that benefit
aintain audited financial statements; the company must maintain a minimum specified level of
ntain any collateral in good working order. The negative side of positive covenants is that the
pany into actions in the future that it would rather not undertake.
covenants protects bondholders from actions by the company that would harm the
wealth. This says nothing about bondholders. Examples of negative covenants would be: the
vel; the company cannot issue new bonds senior to the current bond issue; the company cannot
e company’s actions.
wer the coupon rate. The conversion feature would permit bondholders to benefit if the
may be selling equity at a discounted price.
ny has to pay a higher interest rate. However, if interest rates fall, the company pays a lower

UNAKAN RUMUS PRESENT VALUE

 n, but is made close to whole. Assume a company issues a bond with a make-whole call of
pread for the company’s bond over the life of the bond. Although the spread is correct on
rate varies over the life of the bond, and is higher when the bond has a longer time to maturity.
ury yield at maturity is zero. So, if the bond is called early in its life, the spread above the
hole. If the bond is called late in its life, the spread is too high. This means the interest rate
in a lower present value. Thus, the bondholder is made less than whole. In practical terms,
r price paid to the bondholder when compared to a traditional call feature.

. If the intermediate cash flows for the coupon payments will be difficult, a zero coupon bond
larger payment at maturity.
ter for bondholders, therefore the coupon rate of the bond will likely be lower to sell the bond