chap020 - Chapter 20 Long-Term Debt 20.1 a If you purchase...

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Unformatted text preview: Chapter 20: Long-Term Debt 20.1 a. If you purchase the bond on March 1, you owe the seller two months of interest. The seller owned the bond for two months since the last interest payment date (January 1). She is entitled to the interest earned during those two months. Since Raeo Corp.'s interest payment will not go to her, you must pay it to her now. The interest rate on the bond is 10%. The interest per month is 0.8333% (=10% / 12). 1.6667% (= 0.8333% x 2) is the interest for two months. The bonds are selling at 100, 100% of face value. If today is March 1, you will pay 100% of the face plus 1.6667% for the bond. If the face value of the bonds is $1,000, then you will pay $1,000 + $1,000 (0.016667) = $1,016.67. b. If you purchase the bond on October 1, you owe the seller three months of interest. The seller owned the bond for three months since the last interest payment date (July 1). She is entitled to the interest earned during those three months. Since Raeo Corp.'s interest payment will not go to her, you must pay it to her now. The interest rate on the bond is 10%. The interest per month is 0.8333% (= 10% / 12). 2.5% (0.8333% x 3) is the interest for three months. The bonds are selling at 100, 100% of face value. If today is October 1, you will pay 100% of the face value plus 2.5% for the bond. If the face value of the bonds is $1,000, then you will pay $1,000 + $1,000 (0.025) = $1,025. Since July 1 is an interest payment date, there is no accrued interest on the Raeo bonds. If today is July 1, you will pay 100% of the face value for the bond. If the face value of the bonds is $1,000, then you will pay $1,000. If you purchase the bond on August 15, you owe the seller six weeks of interest. The seller owned the bond for six weeks since the last interest payment date (July 1). She is entitled to the interest earned during those six weeks (a month and a half). Since Raeo Corp.'s interest payment will not go to her, you must pay it to her now. The interest rate on the bond is 10%. The interest per two week period is 0.41667% (10% / 24). 1.25% (=0.41667% x 3) is the interest for one and a half months. The bonds are selling at 100, 100% of face value. If today is August 15, you will pay 100% of the face plus 1.25% for the bond. If the face value of the bonds is $1,000, then you will pay $1,000 + $1,000 (0.0125) = $1,012.50. 20.2 a. b. c. d. A protective covenant is the part of an indenture or loan agreement that limits the actions of the borrowing company. A negative covenant prohibits actions that the company may want to take. Examples include limits on dividends, inability to pledge assets, prohibition of mergers and prohibitions on additional issue of long-term debt. A positive covenant specifies actions that the firm is obliged to take. Examples include maintaining a minimum level of working capital and furnishing additional financial statements to the lender. A sinking fund is an account managed by a bond trustee for the purpose of repaying bonds. c. d. Answers to End-of-Chapter Problems B-183 20.3 Sinking funds provide additional security to bonds. If a firm is experiencing financial difficulty, it is likely to have trouble making its sinking fund payments. Thus, the sinking fund provides an early warning system to the bondholders about the quality of the bonds. A drawback to sinking funds is that they give the firm an option that the bondholders may find distasteful. If bond prices are low, the firm may satisfy its sinking fund by buying bonds in the open market. If bond prices are high though, the firm may satisfy its sinking fund by purchasing bonds at face value. Those bonds being repurchased are chosen through a lottery. 20.4 Open-end mortgage is riskier because the firm can issue additional bonds on its property, making the existing bonds riskier. 20.5 The difference between the call price and the face value is the call premium. The first few years during which a company is prohibited from calling its bonds is the call-protected period (or the grace period). 20.6 a. If KIC's bonds are non-callable, the price today is the PV of the coupon, which will be received at the end of the next year plus the expected value of the bond one year hence. The price of the bond one year from now will depend upon the interest rate which prevails in the market. If the interest rate is 14%, the price of the KIC bond will be $857.14 (= $120 / 0.14). If the interest rate is 7%, the price of the KIC bond will be $1,714.29 (=$120 / 0.07). The coupon which the KIC bond will pay is 12% of the face, or $120 (=0.12 x $1,000). The expected price of the bond is 0.5x($857.14) + 0.5x($1,714.29) = $1,285.71. Discounting by the prevailing market interest rate yields the current price of the KIC bond. P = ($120 + $1,285.71) / 1.11 = $1,266.41 [Note for students who have studied term structure: the assumption of risk-neutrality implies that the forward rate is equal to the expected future spot rate.] If the KIC bond is callable, then the bond value will be less than the amount computed in part a. If the bond price rises above $1,450, KIC will call it. The call will effectively transfer wealth from the bondholders to the stockholders. b. 20.7 If interest rates rise to 15%, the price of the Bowdeen bonds will fall. If the price of the firm's bonds is low, Bowdeen will not call them. The firm would be foolish to pay the call price for something worth less than the call price. In this case, the bondholders will receive the coupon payment, C. They will still be holding a bond worth C/0.15. Their total holding will be C + C / 0.15. If interest rates fall to 8%, it is highly likely that the price of the bonds will rise above the call price. If this happens, Bowdeen will call the bonds. In this case, the bondholders will receive the call price, $1,250, plus the coupon payment, C. The selling price today of the bonds is the PV of the expected payoffs to the bondholders. The expected payoff is 0.6 (C + C / 0.15) + 0.4 (C + $1,250). Since Bowdeen wants today's price of the bonds to be $1,000, discount the expected payoffs at the current rate of interest and solve for C. $1,000 = [0.6 (C + C/0.15) + 0.4 (C + $1,250)] / 1.12 C = $124.00 The coupon payment for the year must be $124.00. Thus, the coupon rate which ensures that the bonds will sell at par is 0.124 (=$124.00 / $1,000). B-184 Answers to End-of-Chapter Problems 20.8 a. b. c. The value of the non-callable bond is given by: VNC = [$80 + 0.65 ($80 / 0.06) + 0.35 ($80 / 0.09)] / 1.08 = $1,164.61 Let C = Call Premium. The value of the callable bond is: VC = [C+ 0.65 ($1,000 + C) + 0.35 (C / 0.09)] / 1.08 Set VC = $1,000 and solve for C. C = $77.63. To the company, the value of the call provision will be given by the difference between the value of an outstanding, non-callable bond and the call provision. Non-callable bond value = $77.63 / 0.06 = $1,293.83 Value to the company of the call provision = [0.65 ($1,293.83 - $1,077.63)] / 1.08 = $130.12 20.9 Next year's bond price if it is non-callable: 40% chance: (1,000 x 9%) /12% = $750 60% chance: (1,000 x 9%) / 6% = $1,500 > $1,150 So if the interest rate falls to 6%, New Business Venture Inc. would call back its bond at $1,150. So current bond price = [90 + (40% x 750 + 60% x 1,150)] / (1 + 10%) = $981.82 20.10 The NPV of the refunding is the difference between the gain from refunding and the refunding costs. Gain = B (r1 - r2) / r2 Cost = (CB) / F + K Where C = the call premium F = the face value B = the par value of the old bonds K = the issuing costs r1 = the coupon rate of the old bonds and r2 = the coupon rate of the new bonds. Gain = $500 million (0.09 - 0.07) / 0.07 = $142,857,143 Cost = 90 ($500 million) / $1,000 + $80 million = $125 million NPV = $142,857,143 - $125,000,000 = $17,857,143 20.11 NPV = 250 x (0.08 - r2) / r2 - 0.12 x 250 x 0.65 = 0 r2 = 7.42% Refinancing is a wise option if borrowing costs are below 7.42%. 20.12 8% perpetual bond: NPV = 75 x (8% - 7%) / 7% - 75 x 8.5% -10 = -$5.66 million < 0 9% perpetual bond: NPV = 87.5 x (9% - 7.25%) - 87.5 x 9.5% - 12 = $0.8082 million So Ms. Kimberly should recommend the re-financing of the 9% perpetual bond, since the NPV of the refunding is $0.8082 million. 20.13 Bonds with an S&P's rating of BB and below or a Moody's rating of Ba and below are called junk bonds (or below-investment grade bonds). The recent controversies of junk bonds are: i. Junk bonds increase the firm's interest deduction. ii. Junk bonds increase the possibility of high leverage, which may lead to wholesale default in economic downturns. iii. The recent wave of mergers financed by junk bonds has frequently resulted in dislocations and loss of jobs. Answers to End-of-Chapter Problems B-185 20.14 a. b. c. For a floating rate bond, the coupon payments are adjustable. The adjustments are usually tied to an interest rate index. Deep discount bonds are also called pure discount bonds or zero coupon bonds. As the latter name implies, these bonds do not pay a coupon. To generate a return, these bonds are sold at prices well below par. Income bonds are similar to conventional bonds, except their coupon payments are tied to the firm's income. The bondholders are paid only if the firm generates enough income to do so. These bonds are attractive for firms to issue because if the firm cannot make an interest payment, it is not in default. Characteristic a. Require SEC registration b. Higher interest cost c. Higher fixed cost d. Quicker access to funds e. Active secondary market f. Easily renegotiated g. Lower floatation costs h. Require regular amortization i Ease of repurchase at favorable prices j. High total cost to small borrowers k. Flexible terms l. Require less intensive investigation Public issues Yes No Yes No Yes No No Yes Yes Yes No Yes Direct financing No Yes No Yes No Yes Yes No No No Yes No 20.15 20.16 a. Yes. The statement is true. In an efficient market, the callable bonds will be sold at a lower price than that of the non-callable bonds, other things being equal. This is because the holder of callable bonds effectively sold a call option to the bond issuer. Since the issuer holds the right to call the bonds, the price of the bonds will reflect the disadvantage to the bondholders and the advantage to the bond issuer (i.e., the bondholder has the obligation to surrender their bonds when the call option is exercised by the bond issuer.) As interest rate falls, the call option of the callable bonds are more likely to be exercised by the bond issuer. Since the non-callable bonds do not have such a drawback, the value of the bond will go up to reflect the decrease in the market rate of interest. Thus, the price of non-callable bonds will move higher than that of the callable bonds. b. B-186 Answers to End-of-Chapter Problems ...
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This note was uploaded on 05/07/2010 for the course FIN 302 taught by Professor Corporationfinance during the Spring '10 term at Uni Potsdam.

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