If the economy continues to be strong, Carson Company may need to increase its p

Question

If the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering issuing stock or bonds to raise funds in the next year.

a. Assume that Carson has two choices to satisfy the increased demand for its products. It could increase production by 10 percent with its existing facilities by obtaining short-term financing to cover the extra production expense and then using a portion of the revenue received to finance this level of production in the future. Alternatively, it could issue bonds and use the proceeds to buy a larger facility that would allow for 50 percent more capacity. Which alternative should Carson select?

b. Carson currently has a large amount of debt, and its assets have already been pledged to back up its existing debt. It does not have additional collateral. At this time, the credit risk premium it would pay is similar in the short-term and long-term debt markets. Does this imply that the cost of financing is the same in both markets?

c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson decide not to include a call provision on the bonds?

d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a private placement of bonds? What type of investor might be interested in participating in a private placement? Do you think Carson could offer the same yield on a private placement as it could on a public placement? Explain.

e. Financial institutions such as insurance companies and pension funds commonly purchase bonds. Explain the flow of funds that runs through these financial institutions and ultimately reaches corporations that issue bonds such as Carson Company.

Explanation / Answer

A) Carson should not buy a larger facility unless it feels confident that it can fully utilize the space.It should consider using up the excess capacity in its existing facility in the short term, andmonitoring economic growth. In this way, it only needs to obtain short-term financing, and canavoid the long-term debt for now. If demand does not increase as anticipated, then it can simplyretire the short-term debt when it matures. Conversely, if Carson is confident that demand willincrease and continue to be strong in the long run, it can issue long-term bonds to finance itsexpansion.

B) No. There is an upward-sloping yield curve, so Carson could obtain short-term financing at alower interest rate than long-term financing

C)The benefit of the call provision is that Carson could retire its bonds before maturity if it wantedto reduce its debt or if interest rates declined and it wanted to refinance at lower rates.Carson would have to pay a higher yield to compensate bondholders if it includes a callprovision on the bonds.

D)

Carson could consider a private placement, as it may be able to reduce its transaction costs if itcan find an institutional investor that would purchase the bonds. A pension fund or insurance company might be willing to participate as an investor in the private placement market. Theinvestor would need to accept the lack of a secondary market for the bond.Carson would probably have to pay a slightly higher yield on the privately placed bonds to reflectthe lack of liquidity (no secondary market) for their bond

E)Insurance companies receive funds from policyholders who pay insurance premiums. They investthe funds until they are needed to cover insurance claims. They use a portion of their funds topurchase bonds. Thus, the money pay for insurance premiums is channeled to the corporationsthat issue bonds.Pension funds receive money that they invest for employees until the money is withdrawn after theemployees retire. The pension funds purchase bonds. Thus, the money contributed by theemployees or their respective employers are channeled to the corporations that issue bonds

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