Name Assignment: Interest Rates And Bond Valuation Case

Name Assignment Interest Rates And Bond Valuation Case

Read the closing case “Financing East Coast Yachts’ Expansion Plans with a Bond Issue” in chapter 5 (see below) of textbook “Corporate finance: Core principles & applications . (4th ed.) by Ross, S., Westerfield, R., Jaffe, J., and Jordan, B. (2014), and answer the four questions posed on this sheet.

1. Prepare a memo describing the effects and advantages or disadvantages of each of the following bond features on the coupon rate of a 20-year bond:

  • The security or collateral provided with the bond
  • The seniority of the bond
  • A sinking fund provision
  • A call provision
  • Any positive covenants
  • Any negative covenants
  • A conversion feature
  • A floating rate coupon

The firm is also considering whether to issue coupon-bearing bonds or zero coupon bonds. The YTM in either case is expected to be 5.5% per annum. The coupon bond would have a 5.5% per annum coupon payable semiannually. The company’s tax rate is 35%.

2. How many of the coupon bonds must East Coast Yachts issue to raise $40,000,000? How many of the zero-coupon bonds must it issue?

3. In 20 years, what will be the principal repayment due if East Coast Yachts issues the coupon bonds? If it issues the zeroes?

4. After considering all relevant factors, what would you recommend the firm do?

Paper For Above instruction

East Coast Yachts stands at a pivotal point in its financial strategy as it seeks to expand through a significant bond issuance. The decision regarding the specific bond features and type of bonds—coupon-bearing or zero coupon—has profound implications for the company's financing costs, flexibility, and investor perception. This paper provides a comprehensive analysis of various bond features, their effects on the coupon rate, and strategic considerations in bond issuance, culminating in an informed recommendation for East Coast Yachts.

Understanding Bond Features and Their Impact on Coupon Rates

Bond features significantly influence the coupon rate demanded by investors, as they reflect the risk profile and flexibility associated with the bond. Each feature has distinct advantages and disadvantages that can impact the company's cost of debt and perceptions among investors.

Security or Collateral

Bonds secured by collateral typically offer lower coupon rates since they are less risky to investors due to the assurance of asset recovery in case of default. For East Coast Yachts, providing collateral—perhaps certain assets or inventory—can reduce borrowing costs but may limit asset flexibility.

Unsecured bonds, on the other hand, carry higher coupon rates to compensate for increased risk, often diluting the company's asset base and potentially reducing operational flexibility.

Seniority

Bonds with seniority are paid before subordinated bonds in case of liquidation, which lowers the risk for investors and thereby reduces the coupon rate. Priority in repayment, however, may increase the company's debt obligations' complexity and cost if multiple layers of seniority exist.

Sinking Fund Provision

A sinking fund obligates the issuer to periodically set aside funds to repay parts of the bond principal. This reduces default risk, leading to a lower coupon rate. Benefits include enhanced creditworthiness, but it can also limit company liquidity and investment flexibility.

Call Provision

A call provision allows the issuer to redeem bonds before maturity, usually when interest rates decline, enabling refinancing. While advantageous strategically, callable bonds are riskier for investors, requiring higher coupon rates to compensate for call risk. The specifics of call dates and prices further influence this risk-profile.

Positive and Negative Covenants

Positive covenants require the issuer to meet certain standards, such as maintaining insurance or working capital thresholds, decreasing perceived risk and bond yields. Negative covenants restrict certain actions—like additional debt issuance—that could jeopardize bondholders, also lowering coupon rates but potentially constraining operational flexibility.

Conversion Feature

Conversion features give bondholders the right to convert bonds into equity, which can reduce coupon rates due to the added value and potential upside for investors. For East Coast Yachts, which is not publicly traded, offering conversions might be complex but could attract certain investors seeking growth options.

Floating Rate Coupon

Floating rate bonds fluctuate with prevailing interest rates, typically resulting in lower initial coupon rates due to reduced interest rate risk for investors. However, they provide the issuer with interest rate flexibility, which can prove beneficial when rates decline.

Coupon Bonds vs. Zero Coupon Bonds: Cost and Strategic Considerations

The decision to issue coupon-bearing or zero coupon bonds impacts the company's cash flow and tax considerations. For a YTM of 5.5%, coupon bonds pay semiannual coupons, leading to periodic interest expenses, whereas zero coupons pay only at maturity, potentially offering tax benefits due to deferral.

The company's tax rate of 35% enhances the attractiveness of coupon bonds through the tax shield on interest payments, effectively reducing the after-tax cost of debt. Zero coupon bonds, while potentially offering lower initial coupon rates, result in a large lump-sum repayment, which could strain cash flow but also defer tax payments.

To finance $40 million, East Coast Yachts must calculate the number of bonds based on their issue price, coupon, and face value, considering the impact of tax shields and the issuer's cash flow capabilities.

In 20 years, principal repayment is the face value of bonds issued—typically $1,000 per bond—regardless of coupon type, but the total amount depends on the number issued.

When issuing coupon bonds with a make-whole call provision, the call price is determined based on the Treasury rate plus a spread, which affects investor return expectations.

If East Coast Yachts calls the bonds at a time when the Treasury rate is 4.8%, with a spread of 0.40%, the call price can be calculated by discounting the remaining payments at the make-whole rate, which effectively makes bondholders "whole."

Investors are generally protected under a make-whole provision, but actual compensation depends on prevailing rates at call time and the specifics of the provision.

Conclusion and Recommendations

Given the company's expansion plans and the factors analyzed, issuing non-callable bonds with positive covenants and collateral, possibly with conversion options, seems prudent to balance cost and flexibility. Consulting market conditions, investor appetite, and the company's cash flow projections will further refine the final decision.

Considering the tax advantages, flexibility, and market conditions, issuing coupon bonds with a make-whole feature may be preferable to zero coupon bonds, provided the company anticipates stable or declining interest rates. Conversely, if cash flow management favors deferring payments, zero coupon bonds could be advantageous.

References

  • Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. (2014). Corporate Finance: Core Principles & Applications (4th ed.). McGraw-Hill.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
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