Using a Word document, complete the requirements of the Mini-case “Financing S &

Question

Using a Word document, complete the requirements of the Mini-case “Financing S & S Air’s Expansion Plans with a Bond Issue” on page 238 in the textbook in the form of a memo, as explained in the case.For each of the ten bond features listed, briefly describe the likely impact of each of the features on the coupon rate demanded by potential bond investors when this new bond is issued. Will it cause the necessary coupon rate to be higher or lower?

In addition, for each of the ten bond features listed, briefly describe the advantages or disadvantages, from the company’s perspective, of implementing that feature with the newly issued bond.

Financing S&S Air’s Expansion Plans with a Bond Issue

Mark Sexton and Todd Story, the owners of S&S Air, have decided to expand their operations. They instructed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $35 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Raines and Warren, about which bond features S&S Air should consider and what coupon rate the issue will likely have.

Although Chris is aware of the bond features, he is uncertain about the costs and benefits of some features, so he isn’t sure how each feature would affect the coupon rate of the bond issue. You are Renata’s assistant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or disadvantages of each feature.

QUESTION

The security of the bond—that is, whether the bond has collateral.

The seniority of the bond.

The presence of a sinking fund.

A call provision with specified call dates and call prices.

A deferred call accompanying the call provision.

A make-whole call provision.

Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider.

Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider.

A conversion feature (note that S&S Air is not a publicly traded company).

A floating-rate coupon.

Explanation / Answer

Q: The security of the bond—that is, whether the bond has collateral.

Collateral backed bonds tend to have lower coupon rate as compared to a bond with no collateral, as the collateral serves as a guarantee that in case the bond issuer fails to repay the debt, the collateral can be taken over and liquidated to recover the due amount. Collateral acts as a guarantee for the bond holders.

Q: The seniority of the bond.

Seniority of the bond is indirectly proportional to coupon rate. A firm can have several bonds at different seniority level. However, seniority level determines the rights of the bond holders in case of default by the issuer. A bond that is senior as compared to other bonds would have first right to the liquidation proceeds, incase issuer defaults. This means that he is more secured as compared to lower seniority bond holders and hence has lower coupon rate.

Q: The presence of a sinking fund.

A bond sinking fund is a restricted asset of a corporation that was required to set aside money for redeeming or buying back some of its bonds payable. The bond sinking fund begins when the corporation deposits money with an independent trustee. The trustee then invests the money in order for the balance in the sinking fund to increase. The balance in the sinking fund will also grow from additional required deposits made by the corporation. The bond sinking fund decreases when the trustee purchases or redeems the corporation's bonds. Sinking fund are seen to be less risky as compared to bonds with no sinking fund and hence have lower coupon rates.

Q: A call provision with specified call dates and call prices.

Call provisions considerably alter bond analysis because they add two dimensions of risk to bondholders. First, they present reinvestment risk. When interest rates fall, the bond issuer is more likely to exercise the call provision in order to retire what has become high-interest debt and reissue the debt at the prevailing lower rate. This leaves the investor with cash that must be reinvested in a lower interest rate environment.

Second, call provisions limit a bond's potential price appreciation because when interest rates fall, the price of a callable bond will not go any higher than its call price. Thus, the true yield of a callable bond at any given price is usually lower than its yield to maturity.

Since call provisions are less favorable to bond holders, they are compensated with higher coupon rates.

Q: A deferred call accompanying the call provision.

A deferred call provision gives a bond issuer the right to call or buy back its bonds after an initial deferment period, which might last five, 10 or some other number of years. These bonds have higher coupon rates as compared to bonds with no call provision but lower than bonds with no call protection. It also offers bond holder’s greater stability of cash flow and ties up firm’s arms as it cannot call a bond before deferment period. However as with all callable bonds, there is a price ceiling as well, because when interest rates fall, the price of a callable bond will not go any higher than its call price.

Q: A make-whole call provision

A make-whole call provision is a call provision attached to a bond, whereby the borrower must make a payment to the lender in an amount equal to the net present value of the coupon payments that the lender will forgo if the borrower pays the bonds off early. It ensures that the bond holders get their due if the borrower wants to repay the debt early. It deters borrower from paying off bonds early, because the costs of making those make-whole payments can be very high. Accordingly, make-whole provisions may actually ensure that a bond is not called. Hence their coupon rate is lower than bonds with call options and at par with bonds with no call options.

Q: Any positive covenants.

A positive loan covenant is used to remind the borrower they should be doing certain activities to maintain the financial health and well-being of the business. Thus they help in reducing coupon rates. Possible covenants S&S Air might consider are:

a. Pay all business and employment-related taxes

b. Maintain current financial records

c. Insurance policies for the business and possibly include the lender as a separately named ‘additional insured’ party

d. Maintain the business entity in good standing with the state where it is formed

Q: Any negative covenants

A negative loan covenant is used to create boundaries for the company and its owners. Such boundaries are usually related to financial and ownership matters. Borrower may include negative loan covenants which require the business owner to seek the bank’s permission to take certain actions as such actions may change the business’ capital structure. Thus they help in reducing coupon rates. Possible covenants S&S Air might consider are:

a. Limiting total debt issued by the borrower.

b. Restricting distribution of dividend to shareholders

c. Prevention of a merger or acquisition without the lender’s permission

d. Maintenance of a specific or targeted Debt Service Coverage Ratio

Q: A conversion feature

A conversion feature allows the bond holders to convert their debt into equity if the firm's value is more attractive. Most companies that issue convertible bonds expect investors to convert to stocks before the bonds mature, freeing the company from repaying the bonds with interest. Since it offers flexibility to bond holders, the coupon rates are lower compared to bonds without this feature. However, since S&S Air is not yet a publicly traded company, liquidity of its equity is limited, restricting the lender to convert its bonds. Thus, it might not be useful for S&S Air to issue a bond with this feature.

Q: A floating-rate coupon

A bond with floating-rate coupon pays a variable interest rate depending upon the base rate plus a margin. Since the base rate keeps on changing, the lender gets the market rate as interest. As compared to fixed rate bonds, floating rate bonds have lower coupon rates as the lenders need not be compensated for situation where interest rate rises but coupon remains fixed.

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