q1) The primary purpose of protective covenants is to help -reduce interest rate
ID: 2645852 • Letter: Q
Question
q1)
The primary purpose of protective covenants is to help
-reduce interest rate risk.
-the issuer in case of default.
-protect bondholders from issuer actions.
-bondholders whose bonds are called.
-convert bearer bonds into registered form.
q2)
Managers are going to borrow to finance 50% of the value of new assets. The rest will be financed with equity. They have decided that the correct discount rate to value the project is the average of the firm's estimated 10% cost of equity and the after tax cost of debt. The pre-tax cost of the firm's debt is the yield to maturity of bonds the firm is going to issue. The terms of the bonds are:
settlement 5/5/2014
maturity 5/5/2024
rate 10%
pr 110
redemption 100
frequency 2
basis 0
These terms are from the EXCEL function "Yield".
The firm's marginal tax rate is 25%.
The discount rate the firm uses should be:
8.18%
7.6%
12.1%
7.25%
-reduce interest rate risk.
-the issuer in case of default.
-protect bondholders from issuer actions.
-bondholders whose bonds are called.
-convert bearer bonds into registered form.
q2)
Managers are going to borrow to finance 50% of the value of new assets. The rest will be financed with equity. They have decided that the correct discount rate to value the project is the average of the firm's estimated 10% cost of equity and the after tax cost of debt. The pre-tax cost of the firm's debt is the yield to maturity of bonds the firm is going to issue. The terms of the bonds are:
settlement 5/5/2014
maturity 5/5/2024
rate 10%
pr 110
redemption 100
frequency 2
basis 0
These terms are from the EXCEL function "Yield".
The firm's marginal tax rate is 25%.
The discount rate the firm uses should be:
8.18%
7.6%
12.1%
7.25%
Explanation / Answer
Question 1)
Protect Bondholders from Issuer Actions (which is Option C)
_______________
Details Provided Below
There are 2 types of bond covenants. One is positive (it is also known as protective) and the other one is negative. Positive covenants place restrictions on the bond issuers to undertake actions which are against the interests of the bondholders. A few examples of such types of restrictions include, raising additional debt, making payment of dividends to shareholders, etc. Any violation of such covenants can result in imposition of penalty in the form of downgrading of bond's rating.
_____________
Question 2)
The discount rate would be same as weighted average cost of capital. The formula for calculating WACC is:
WACC = Weight of Debt*After Tax Cost of Debt + Weight of Equity*Cost of Equity
Cost of debt will be calculated with the use of yield function in EXCEL (as required in the question). The Yield Function is:
Cost of Debt = Yield(Settlement, Maturity,Rate,Price,Redemption,Frequency,Basis)
After Tax Cost of Debt = Cost of Debt*(1-Tax Rate)
_____________
Using the information provided in the question, we get,
Cost of Debt = Yield(5/5/2014,5/5/,2024,10%,110,2,0) = 8.50%
After Tax Cost of Debt = 8.50%*(1-25%) = 6.37%
Weight of Debt = 50% and Weight of Equity = 50% (provided in the question)
____________
Discount Rate (WACC) = 50%*6.37% + 50%*10% = 8.18% (which is Option A)
_____________
Question 3)
Present value is the discounted value of all future cash flows. The formula for calculating present value is:
Present Value = Cash Flow Year 0 + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 2/(1+Discount Rate)^2 + Cash Flow Year 3/(1+Discount Rate)^3 + Cash Flow Year 4/(1+Discount Rate)^4+....................+ Cash Flow Year 9/(1+Discount Rate)^9 + Cash Flow Year 10/(1+Discount Rate)^10
_____________
Using the information provided in the question, we get,
Present Value = 85/(1+10%)^1 + 90/(1+10%)^2 + 130/(1+10%)^3 + 140/(1+10%)^4 + 150/(1+10%)^5 + 90/(1+10%)^6 + 80/(1+10%)^7 + 70/(1+10%)^8 + 60/(1+10%)^9 + 50/(1+10%)^10 = $607.32 (which is Option B)
_____________
Question 4)
Maturity (which is Option C)
_______________
Details Provided Below
The treasury yield curve highlights the relationship between the yields and maturities of treasury fixed income securities. It is frequently used to highlight/check the yields of bonds/notes with fixed maturities such as 1, 3 and 6 months.
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