Butcher Company plans to issue bonds to raise $10 million to finance expansion.
ID: 2733945 • Letter: B
Question
Butcher Company plans to issue bonds to raise $10 million to finance expansion. It could use 10-year mortgage bonds backed by the firm's fixed assets, 10-year debentures that are not backed by any specific assets but are backed by the firm's general earning power, or 10-year subordinated debentures that would be subordinated to all of the firm's other debt. If it uses mortgage bonds, they would be rated A by Moody's and S&P, and their market interest rate would be 7.5%. Given this information, which of the following statements is most correct? a. The subordinated debentures would be rated highest, probably AA. b. Given the 7.5% interest rate on the mortgage bonds, the subordinated debentures might carry an interest rate of 8.0% and the plain debentures a rate of 8.5%. c. Since bond ratings are highly subjective, information about the rating and interest rate on the A-rated bond tells us nothing about how the two types of debentures would be rated, or about their likely interest rates. d. The debentures would be rated highest, probably AA. e. Given the 7.5% interest rate on the mortgage bonds, the plain debentures might carry an interest rate of 8.0% and the subordinated debentures a rate of 8.5%.
Explanation / Answer
e). Given the 7.5% interest rate on the mortgage bonds, the plain debentures might carry an interest rate of 8.0% and the subordinated debentures a rate of 8.5%.
Explanation:- Option e) is the most correct. The plain debentures and mortgage bonds carry similar maturity and risk, thus the interest rate on plain debentures will be very near to mortgage bonds. According to this, option e) "Given the 7.5% interest rate on the mortgage bonds, the plain debentures might carry an interest rate of 8.0% and the subordinated debentures a rate of 8.5%." is the most correct statement.
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