Question

Part I: Initial Expansion Gonzales is a closely held corporation considering a major expansion. The proposed expansion would require the firm to raise $10 million in additional capital. Because Gonzales currently has 50 percent debt and because the family members already have all their funds tied up in the business, the owners cannot supply any additional equity, so the company will have to sell stock to the public. The family wants to ensure that it will retain control of the company. This offering would be Gonzales’s first stock sale, and the owners are not sure exactly what would be involved. For this reason, they have asked you to research the process and to help them decide how to raise the needed capital.

Part II: Subsequent Expansions A few years after the initial expansion, Gonzales wants to build a plant and finance an operation that would manufacture and distribute its homemade salsa and related products to supermarkets throughout the United States and Mexico. Mr. Gonzales, CEO and family head, has begun planning this venture, even though construction is not expected to begin until the current expansion is complete and the company is financially stable, which might take several years. Even so, Mr. Gonzales has some ideas that he would like you to examine. The project’s estimated cost is $30 million, which will be used to build a manufacturing facility and to set up the necessary distribution system. Gonzales tentatively plans to raise the $30 million by selling 10-year bonds, and its investment bankers have indicated that the firm can use either regular or zero coupon bonds. Regular coupon bonds would sell at par and would have annual payment coupons of 12 percent; zero coupon bonds would also be priced to yield 12 percent annually. Either bond would be callable after three years, on the anniversary date of the issue. As part of your analysis, you have been asked to answer the following questions:

Gonzales’s bonds will be callable after three years. If the bonds were not callable, would the required interest rate be higher or lower than 12 percent? What would be the effect on the rate if the bonds were callable immediately? What are the advantages to Gonzales of making the bonds callable?

At the time of the bond issue, Gonzales expects to be an A-rated firm. Suppose the firm’s bond rating was (1) lowered to BBB or (2) raised to AA. Who would make these changes, and what would they mean? How would these changes affect the interest rate required on Gonzales’ new long-term debt and the market value of Gonzales’ outstanding debt?

Answer 1

If the bonds were not callable, would the required interest rate be lower than 12 percent as there is no risk for the buyers that the company may call off the bond and they will not get the further coupons after the bond is called off. So the reinvestment risk of the capital is not there.

Rate of Bonds will increase if the bond were callable immediately as there is a risk the buyer has to face that is to lose coupons, that is if the bonds are immediately called off then buyers will not get the coupons further and they have also to reinvest the principal.

The advantages to Gonzales of making the bonds callable are that it allows them to take of their bonds of a possible drop in interest rates of the market at some point in the future and issue a new bond at that price it will reduce their cost of capital. This is similar to a mortgage borrower refinancing at a lower rate. The prior mortgage with the higher interest rate is paid off, with the borrower obtaining a new mortgage at the lower rate.

The bond often defines the callable amount to recall the bond that may be greater than the par value. The price of bonds has an inverse relationship with interest rates. Bond prices go up as interest rates fall. Thus, it is advantageous for a company to pay off the debt by recalling the bond at above par value.

Another advantage is that issuing a callable bond as a little high interest will reduce the time of selling the bonds as it will attract investors

The ratings like A, AA or BB are the companies performance rating and it is also seen as the risk rating by the investors i.e. higher the rating means lower the risk. Gonzales expects to be an A-rated firm. Suppose the firm’s bond rating was (1) lowered to BBB then the investors will see this as a bad signal. They will consider it a high-risk company to invest in and may not invest much. To attract investors Gonzales has to increase the interest rate of their bonds. For new long term debt, the interest rate will also be high and for current debt, the market value will see as a low capable company to pay it.

(2) Raised to AA, Then the investor will see this as a good signal and want to invest in it. It will give the face of low-risk company and will attract more investors. Now the company has the option to decrease the interest rates of the bonds and for the debt, it will get a low-interest rate debt and in the market, the current debt will be seen as that the company can pay it off and will have a beefer impression than before.