The open ended sortg indenture of the Va1ley Pover on peroies it to issue Additi

Question

The open ended sortg indenture of the Va1ley Pover on peroies it to issue Additional bonds froa tine to tine, provided chat such ssues do not exceed 66 2/3 per of additional property pledged, and provided chat average earnings or bond interest in the 3 preceding years have been equal to 2 1/2 tines the interest requirement on che total asount e outstanding. The corporation's outstanding mortgase consist ot..series.A.1asue of $10 "illion, bearing interest A issue of $10 1111on, bear at s percent.and a. Series B issue of $20 ·illion, bearing interest at 5 1/2 percent. It nov vants to put out Series C issue for the largest peraissible amount to finance the acquisition of land and, generating tacilities, which yill cost $24 illion and vhiclh il be pledged under the indenture. Investaent bankers advise the corporation that to find a market the new bonds aust bear interest at 6 1/2 percent. On the basis of this rate, and assuming that average annual earnings available for bond interest in the past 3-years have been $6,800,000, determine the aaxinua a-ount of Series C bonds that the corporation nay issue while keeping within the linits of the indenture restrictions

Explanation / Answer

Interest amount of Series A issue = $10 million*5% = $0.50 million

Interest amount of Series B issue = $20 million*5.5% = $1.10 million

Let the value of Series C issue be $x million. As the issue cannot exceed 66 2/3% (or 66.6667%) of the additional property pledged so, x<=66 2/3% of $24 million

or x<=$16 million (1st constraint)

The 2nd constraint is with regards to average earnings which should be 2.5 times the interest requirement.

Total interest requirement = $0.50 million+$1.10 million+0.065x

= 1.6+0.065x

Annual earnings available = 6,800,000 or $6.8 million

Thus 2.5*(1.6+0.065x)<=6.8

or 0.065x<=1.12

or x<=$17.23 million (second constraint)

1st constraint is that x<=$16 million and 2nd constraint is that x<=17.23 million.

Thus x = $16 million and this is the maximum amount of series C bonds that can be issued.

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