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bond case analysis
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CASE STUDY BOND VALUATION
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 Kim McKenzie, 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 benefi ts of some features, so he isn’t sure how each feature would affect the coupon rate of the bond issue. You are Kim’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: QUESTIONS
- 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
A rule of thumb with bond provisions is to determine who benefits by the provision. If the company benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a lower coupon rate.
- A bond with collateral will have a lower coupon rate. Bondholders have the claim on the collateral, even in bankruptcy. Collateral provides an asset that bondholders can claim, which lowers their risk in default. The downside of collateral is that the company generally cannot sell the asset used as collateral, and they will generally have to keep the asset in good working order.
The bonds can be secured or unsecured. Secured bonds will have an asset pledged on the debt which acts as collateral security. Thus, with the collateral the bondholder can claim in case of the default by the issuer.
THus, the bonds with security or collateral will have lower coupon rate than unsecured loans. Because the risk associated with the bondholder is less as it is secured with an asset. The bondholder can claim even in case of bankruptcy.
The advantage of issung secured bond is that bonds will be able to pay a lower coupon rate. While the disadvantage is that the copany should keep this pledged asset and maintain its value and ensure good working condition.
Thus, bonds with collateral will have lower coupon rate. 2. The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy proceedings before subordinated bonds receive any payment. A potential problem may arise in that the bond covenant may restrict the company from issuing any future bonds senior to the current bonds. 3. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The problem with a sinking fund is that the company must make the interim payments into a sinking fund or face default. This means the company must be able to generate these cash flows. 4. A provision with a specific call date and prices would increase the coupon rate. The call provision would only be used when it is to the company’s advantage, thus the bondholder’s disadvantage. The downside is the higher coupon rate. The company benefits by being able to refinance at a lower rate if interest rates fall significantly, that is, enough to offset the call provision cost. 5. A deferred call would reduce the coupon rate relative to a call provision with a deferred call. The bond will still have a higher rate relative to a plain vanilla bond. The deferred call means that the company cannot call the bond for a specified period. This offers the bondholders protection for this period. The disadvantage of a deferred call is that the company cannot call the bond during the call protection period. Interest rates could potentially fall to the point where it would be beneficial for the company to call the bond, yet the company is unable to do so. 6. A make-whole call provision should lower the coupon rate in comparison to a call provision with specific dates since the make-whole call repays the bondholder the present value of the future cash flows. However, a mak -whole call provision should not affect the coupon rate in comparison to a plain vanilla bond. Since the bondholders are made whole, they should be indifferent between a plain vanilla bond and a make-whole bond. If a bond with a make-whole provision is called, bondholders receive the market value of the bond, which they can reinvest in another bond with similar characteristics. If we compare this to a bond with a specific call price, investors rarely receive the full market value of the future cash flows. 7. A positive covenant would reduce the coupon rate. The presence of positive covenants protects bondholders by forcing the company to undertake actions that benefit bondholders. Examples of positive covenants would be: the company must maintain audited financial statements; the company must maintain a minimum specified level of working capital or a minimum specified current ratio; the company must maintain any collateral in good working order. The negative side of positive covenants is that the company is restricted in its actions. The positive covenant may force the company into actions in the future that it would rather not undertake. 8. A negative covenant would reduce the coupon rate. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. Remember, the goal of a corporation is to maximize shareholder wealth. This says nothing about bondholders. Examples of negative covenants would be: the company cannot increase dividends, or at least increase beyond a specified level; the company cannot issue new bonds senior to the current bond issue; the company cannot sell any collateral. The downside of negative covenants is the restriction of the company’s actions. 9. Even though the company is not public, a conversion feature would likely lower the coupon rate. The conversion feature would permit bondholders to benefit if the company does well and also goes public. The downside is that the company may be selling equity at a discounted price.
bond case analysis
Course: financial management
University: Universitas Katolik Widya Mandala Surabaya
