Question

PANSION PLANS ase FINANCING EAST COAST YACHTS'S EXPANSION P WITH A BOND ISSUE er 3), Larissa After Dan's EFN analysis for East Coast Yachts (see the Mini Case in Chapter 3). LA has decided to expand the company's operations. She has asked Dan to enlist an underw to help sell $50 million in new 20-year bonds to finance new construction. Dan has en into discussions with Kendahl Shoemaker, an underwriter from the firm of Crowe & Malla about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the coste and benefits of some of them, so he isn't clear on how each feature would affect the coupon rate of the bond issue. 1. You are Kendahl's assistant and she has asked you to prepare a memo to Dan describing the effect of each of the following bond features on the coupon rate of the bond. She also would like you to list any advantages or disadvantages of each feature. a. The security of the bond, that is, whether or not the bond has collateral. b. The seniority of the bond. c. The presence of a sinking fund. d. A call provision with specified call dates and call prices. e. A deferred call accompanying the above call provision. f. A make-whole call provision. 8. Any positive covenants. Also, discuss several possible positive covenants East Yachts might consider.

Answer 1

1]

a]

If a bond has collateral, the coupon rate will be lower. This is because if the bond has collateral, the risk of the bond is reduced, and therefore the return demanded by bond investors will be lower.

Advantage - A lower coupon can be paid.

Disadvantage - Assets of the firm have to hypothecated against the bond in a legal agreement.

b]

A senior bond will have a lower coupon rate. This is because a senior bond will have preference to be repaid in the event of liquidation. Thus, the bond has lower risk, and the bond investors will have a lower required return.

Advantage - Attracts bond investors.

Disadvantage - Senior bonds usually have covenants attached.

c]

The presence of a sinking fund will lower the coupon rate payable. This is because a sinking fund will reduce the risk of the bond, and reduce the required return of bond investors.

Advantage - The company will have sufficient funds set aside when the bond becomes due.

Disadvantage - Money set aside in the sinking fund is not available for investment or to pay dividends.

d]

With a call provision, the coupon rate will be higher. This is because with a call provision, the company can call the bonds if interest rates fall. This increased the reinvestment risk for the bond investor. Therefore, the coupon rate will be higher to compensate the bond investor for the higher risk.

Advantage - The company can refinance the debt if interest rates fall.

Disadvantage - The coupon rate has to be higher to compensate the bond investor for higher risk.