BONDS FEATURES
Financing East Coasts Expansion Plans with a Bonds Issue
1. Describe the following bond features and their effect on the coupon rate
The security of the bond, that is, whether or not it has collateral
A collateralized bond has a lower coupon rate, because the risk of loss is also low. In the case of bankruptcy on the part of East Cost Yacht, the bondholders still have a claim on the collateral. As such, collateral lowers the risk of loss for the bondholders. However, the primary disadvantage of a collateralized bond is that the company cannot sell the asset(s) it has kept as collateral and has to keep the same in good condition at all times.
Bond seniority
Seniority is a term used to refer to the order of repayment in the event of bankruptcy or a sale. Senior bonds are paid before junior bonds in the event of liquidation (Jordan, Westerfield & Ross, 2010). The higher the bonds seniority, therefore, the lower the coupon rate as senior bondholders are given preference over junior bondholders in the event of liquidation, implying that they have a lower risk of loss. Seniority thus helps to mitigate risks for bondholders. However holders of senior bonds may at times be restricted from taking up more senior bonds (Jordan et al., 2010).
Presence of sinking fund
A sinking fund is a restricted account containing money that a corporation sets aside to pay off a bond or debt (Jordan et al., 2010). It reduces the coupon rate as it serves as a guarantee for borrowers and hence lowers their risk of loss. The primary disadvantage of a sinking fund is that it forces the company to generate extra cash flows to be able to make regular payment into the fund, failure to which it faces default (Jordan et al., 2010).
Call provision with specified call dates and prices
A call provision is a clause in a bond that allows the issuer to repurchase and retire the bond before maturity, in this case, before 30 years. Call provisions with specific call dates and prices increase the coupon rate as the call provisions are often to the advantage of the company and the disadvantage of the bondholder. The high interest rate is the main disadvantage as it forces the company to pay more to the bondholder than it would under normal circumstances (Jordan et al., 2010). However, the greatest advantage of such provisions is that the company is able to refinance at a reduced rate when conditions are favorable such as if there is a huge fall in the rate of interest (Jordan et al., 2010).
A deferred call accompanying the above call provision
A deferred call is a provision prohibiting a company from calling the bond before a certain date (Jordan et al., 2010). The bond is considered call-protected during the specified period. The deferred call offers holders of bonds some form of protection, which means a lower risk, and hence, lower coupon rate (Jordan et al., 2010). Thus, a bond with a deferred call provision accompanying a call provision with specified dates will have a lower coupon rate than that without such a provision (Jordan et al., 2010). The main advantage of deferred call provisions is that they offer some form of protection to bondholders. However, the main disadvantage is that they do not allow the company to call the bond during the...
…= 0.055
Thus: 0.055 = [$1,000/P)1/30] 1 = $200.64
The number of zeroes to be issued is given by:
= 224, 283 zero-coupon bonds
3. In 30 years, what will be the principal repayment due if East Coast issues:
a) Coupon bonds
At maturity, coupon bonds only receive the face value of the bond and interest accrued over the 30th year calculated using simple interest (Gallagher & Andrew, 2007);
Interest for the 30th year = 1000 x 5.5% x 1 = $55
Less taxes at rate of 35 percent;
Interest payable = 0.65 x $55 = $35.75
Face value of bond = $1,000 + $35.75 = $1,035.75
b) Zero-Coupon bonds
For zero-coupon bonds, the bondholder does not receive interim interest payments, and all accrued interest is paid less taxes, in addition to the face value of the bond at maturity (Gallagher & Andrew, 2007). Accrued interest will be given by simple interest with the YTM serving as the internal rate of return: Interest = 1000 x 5.5% x 30= 0.055 X $1,000 = $1,650
Subtracting annual taxes at a tax rate of 35 percent
Interest payable at maturity = 0.65 x $1,650 x 30 = $1,072.50
Principal repayment = $1,000 (face value) + $1,072.50 = $2,072.50 per bond
4. What are the companys considerations in issuing a coupon bond compared to a zero-coupon bond?
One of the primary considerations is the stability of expected cash flows (Gallagher & Andrew, 2007). Coupon bonds attract periodic interest payments that the company will be forced to generate revenues in order to pay. Zero coupon bonds, on the other hand, are paid at maturity, eliminating the need for interim interest payments. Thus, if the company expects stable cash flows over the next 30 years, it could go for the coupon bond. However, if…
