1. Why would a company pay to have its public debt rated by a major rating agency (such as Moody’s or Standard and Poor’s)? Why might a firm decide not to have its debt rated? (PHBWBL p. 367, Q2)
2. Wollongong Construction Company follows the percentage-of-completion method for reporting long-term contract revenues. The percentage of completion is based on the cost of materials shipped to the project site as a percentage of total expected material costs (i.e. expenses are recorded during the life of the project and not at the end of the project) Wollongong’s major debt agreement includes restrictions on net worth, interest coverage, and minimum working capital requirements.
A leading analyst claims that ‘the company is buying its way out of these covenants by spending cash and buying materials, even when they are not needed’.
(a) Explain how this might be possible.
(b) Assuming the analyst is correct, will this behaviour have any impact on the company’s Z-score? Explain. (PHBWBL p. 367, Qs 7 & 8, adapted)
3. A leading retailer finds itself in a financial bind. It doesn’t have sufficient cash flow from operations to finance its growth, and it is close to violating the maximum debt-to-assets ratio allowed by its covenants. The Vice-President for Marketing suggests: “We can raise cash for our growth by selling the existing stores and leasing them back. This source of financing is cheap, since it avoids violating either the debt-to-assets or interest coverage ratios in our covenants.” Do you agree with his analysis? Why or why not? As the firm’s banker, how would you view this arrangement? (PHBWBL p. 367, Q9)
B. Case Study
Amazon.com in year 2000 (PHBWBL pp. 369-375). Read this case and answer the following questions:
1. What is your assessment of the long-term viability of Amazon's business model?
2. Do you agree with Ravi Suria's analysis of the credit risks associated with Amazon's bonds?
(Support your answer with relevant ratio analysis. A spreadsheet file template of Amazon’s financial Statements 1997-1999 is available on Blackboard).)
3. Why did the markets (both bond and stock) react so significantly to Suria's report?
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