Acc week 3 discussion Lawrence Keen is the President of the Safe Water Filter Co

Question

Acc week 3 discussion

Lawrence Keen is the President of the Safe Water Filter Company. As President, he is in control of the issuance of stocks and Bonds. Three years ago when the company needed cash, Lawrence purchased from the company a $100,000, 4 percent, 10-year unsecured bond. The interest rate has begun to increase. Lawrence suggests that the company refinance the bonds to extend the life of the bonds, even though the interest rate has increased to 7 percent.

Using the following formula:

I = Principal * Rate * Time

LegacyFinancing:

I = $100,000 * 4% * 10 = $40,000

ProposedFinancing:

I = $100,000 * 7% * 10 = $70,000

If the legacy financing arrangement was in place for the entire 10-year period, Mr. Keen would have earned $40,000 in interest income. However, if the company refinances for a longer term and at a higher rate, it will allow Mr. Keen the opportunity to earn $70,000 over 10 years.

Does allowing Mr. Keen the opportunity to earn additional interest income under the revised financing agreement create a conflict of interest? Why or why not?

Explanation / Answer

No, The additonal interest income under the revised financing will not create conflict of Interest

Explaination: There is a inverse relationship between the interest rate and the bond yield. As the interest rate increases, the price of the bond reduces and the yield of the bond will become less.

This means the as the interest rate becomes more than the coupon rate , as is the case here (chnages from 4% to 7%), the price of the bond will be lower than the face value. hence the yield to maturity of the bond will reduce for the bondholder.

Hence the returns to Mr. Lawerence will be reduced.

The compnay however will continue to pay 4% ineterest on the bond and this is fixed and will not fluctuate with the chnage in the interest rates.

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