Chapter 21: Long-Term Debt

Questions and Problems:

21.1 When you purchase a bond on a day other than a coupon payment date, there will be an adjustment in the
actual price paid. Since coupons are paid in arrears, you can think of them as earned monthly, but paid
at the end of each 6–month period. Therefore, if you buy a bond during any 6–month period, at the end
of that period you will receive a coupon for some months you did not "earn." Those months of coupon
must be paid to the one who earned them –– the seller, and you make that payment at the time you buy
the bond.

In each of the following, the rate is 7%, so the monthly interest is 7%/12 = 0.583%. Since the bonds are
trading at 100 (or 100% of par), you will pay
Pr i ce=(100 %+ N x 0.583 %)
where N is the number of months since the last coupon payment.

a. If you purchase the bond on April 1, you owe the seller three months of interest. Therefore, N =3,
and the price is:

Pr i ce=100 % +(3 x 0.583 %)=101.75 %

If the face value of the bonds is $1,000, then you will pay $1,000 + $1,000 (0.0175) = $1,017.50.

b. If you purchase the bond on September 1, you owe the seller two months of interest.
Therefore, N=2, and the price is

Pr i ce=100 % +(2 x 0.583 %)=101.17 %

If the face value of the bonds is $1,000, then you will pay $1,000 + $1,000 (0.0117) = $1,011.70.

c. Since July 1 is an interest payment date, there is no accrued interest on the bonds. If today is July 1,
you will pay 100% of the face value for the bond. If the face value of the bonds is $1,000, then you
will pay $1,000.

d. If you purchase the bond on August 15, you owe the seller six weeks (1 1/2 months) of interest.

Therefore, N =1.50, and the price is

Pr i ce=100 % +(1.5 x 0.583 %)=100.8745 %

If the face value of the bonds is $1,000, then you will pay $1,000 + $1,000 (0.008745) = $1,008.75

21.2 Sinking funds provide additional security to bondholders. If a firm is experiencing financial difficulty, it
is likely to have trouble making its sinking fund payments. Thus, the sinking fund provides an early
warning system to the bondholders about the quality of the bonds.

A drawback to sinking funds is that they give the firm an option that the bondholders may find
distasteful. If bond prices are low, the firm may satisfy its sinking fund by buying bonds in the open
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 market. If bond prices are high though, the firm may satisfy its sinking fund by purchasing bonds at face
value. Those bonds being repurchased are chosen through a lottery.

21.3 Characteristic Public Issues Direct Financing

a. Require OSC registration Yes No

b. Higher interest cost No Yes
c. Higher fixed cost Yes No
d. Quicker access to funds No Yes
e. Active secondary market Yes No
f. Easily renegotiated No Yes
g. Lower floatation costs No Yes
h. Require regular amortization Yes No
i Ease of repurchase at favorable prices Yes No
j. High total cost to small borrowers Yes No
k. Flexible terms No Yes
l. Require less intensive investigation Yes No

21.4 The difference between the call price and the face value is the call premium. The first few years during
which a company is prohibited from calling its bonds is the call–protected period (or the grace period).

21.5 This is a new corporate debt with a different call provision. This new feature is designed to make it
unattractive for the issuer ever to call the bond. Unlike the standard call, with the Canada plus, the exact
amount of the call premium is not set at the time of issuance. The Canada plus call stipulates that, in the
event of a call, the issuing company must provide a call premium which will compensate the holder for
the difference in interest between the original bond and the new debt issued to replace it. This
compensation cancels the borrower’s benefit of being able to call the debt, resulting in the fact that a call
will not occur.

21.6 There are two benefits. First, the company can take advantage of interest rate declines by calling in an
issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant
for some reason. Calling the issue does this. The cost to the company is a higher coupon. A put provision
is desirable from an investor’s standpoint, so it helps the company by reducing the coupon rate on the
bond. The cost to the company is that it may have to buy back the bond at an unattractive price.

21.7 Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are used
to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers
also simply ask potential purchasers what coupon rate would be necessary to attract them. The coupon
rate is fixed and determines what the bond’s coupon payments will be. The required return is what
investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required
return are equal only if the bond sells for exactly at par.

21.8 Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell;
many large investors are prohibited from investing in unrated issues.

21.9 A 100–year bond looks like a share of preferred stock. In particular, it is a loan with a life that almost
certainly exceeds the life of the lender, assuming that the lender is an individual. With a junk bond, the
credit risk can be so high that the borrower is almost certain to default, meaning that the creditors are

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 very likely to end up as part owners of the business. In both cases, the “equity in disguise” has a
significant tax advantage.

21.10 If interest rates rise, the price of the bonds will fall. If the price of the bonds is low, the company will not
call them. The firm would be foolish to pay the call price for something worth less than the call price.
In this case, the bondholders will receive the coupon payment, C, plus the present value of the remaining
payments. So, if interest rates rise, the price of the bonds in one year will be:

P1 = C + C/0.10

If interest rates fall, the assumption is that the bonds will be called. In this case, the bondholders will
receive the call price, plus the coupon payment, C. So, the price of the bonds if interest rates fall will be:

P1 = $1,175 + C

The selling price today of the bonds is the PV of the expected payoffs to the bondholders. To find the
coupon rate, we can set the desired issue price equal to the present value of the expected value of end of
year payoffs, and solve for C. Doing so, we find:

P0 = $1,000 = [0.60 × (C + C/0.10) + 0.40 × ($1,175 + C)]/1.09

C = $88.57

So the coupon rate necessary to sell the bonds at par value will be:

Coupon rate = $88.57/$1,000

Coupon rate = 0.0886 or 8.86%

21.11 a. The price of the bond today is the present value of the expected price in one year. So,
the price of the bond in one year if interest rates increase will be:

P1 = $70 + $70/0.09
P1 = $847.78

If interest rates fall, the price if the bond in one year will be:

P1 = $70 + $70/0.05
P1= $1470

Now we can find the price of the bond today, which will be:

P0 = (0.40 × $847.78 + 0.60 × $1,470)/1.07

P0 = $1,141.23

b. If interest rates rise, the price of the bonds will fall. If the price of the bonds is low, the company will
not call them. The firm would be foolish to pay the call price for something worth less than the call
price. In this case, the bondholders will receive the coupon payment, C, plus the present value of the
remaining payments. So, if interest rates rise, the price of the bonds in one year will be:

P1 = C + C/0.09

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 If interest rates fall, the bonds will be called. In this case, the bondholders will receive the call price,
plus the coupon payment, C. The call premium is the same as the coupon rate, so the price of the
bonds if interest rates fall will be:

P1 = ($1,000 + C) + C
P1 = $1,000 + 2 × C

The selling price today of the bonds is the PV of the expected payoffs to the bondholders. To find
the coupon rate, we can set the desired issue price equal to present value of the expected value of end
of year payoffs, and solve for C. Doing so, we find:

P0c= $1,000 = [0.40 × (C + C/0.09) + 0.60 × ($1,000 + 2 × C)]/1.07

C = $77.76

So the coupon rate necessary to sell the bonds at par value will be:

Coupon rate = $77.76/$1,000

Coupon rate = 0.07776 or 7.776%

c. To the company, the value of the call provision is given by the difference between the value of an
outstanding, non–callable bond and the value of the callable bond, with both bonds offering the same
coupon rate. So, the value of a noncallable bond with the same coupon rate would be:

Non–callable bond value

= [0.4 × ($77.76 + $77.76/0.09) + 0.6 × ($77.76 + $77.76/0.05)]/1.07 = $1,267.74

Thus, the value of the call provision to the company is:

Value = $1,267.74 – $1,000

Value = $267.74

Alternatively, the value of the call provision to the company can be determined using the
PV of the expected savings from the provision:

Value = {(0.4 × $0) + 0.6 × [($77.76 + $77.76/0.05) - ($1,000 + 2 × $77.76)]}/1.07 = $267.74

21.12 The price of the bond today is the present value of the expected price in one year. The bond will be
called whenever the price of the bond is greater than the call price of $1,150. First, we need to find the
expected price in one year. If interest rates increase next year, the price of the bond will be the present
value of the perpetual interest payments, plus the interest payment made in one year, so:

P1 = ($110/0.12) + $110
P1 = $1,026.67

This is lower than the call price, so the bond will not be called.

If the interest rates fall next year, the price of the bond will be:

P1 = ($110/0.08) + $110
P1 = $1,485
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 This is higher than the call price, so the bond will be called. The present value of the expected value of
the bond price in one year is:

P0 = [0.35 × $1,026.67 + 0.65 × ($110 + $1,150)]/1.11

P0 = $1,061.56

The value of the call provision to the company can be determined using the PV of the expected
savings from the provision:

Value = {0.35 × $0 + 0.65 × [($110 + $110/0.08) - ($110 + $1,150)]}/1.11 = $131.76

21.13 The annual interest penalty that Whitby would have to pay to call the debt is

[(7.35% + 0.8%) – (5.5% + 0.8%)] × $5,000,000 = $92,500

Calling the debt would generate savings

$5,000,000 × (0.0815 – 0.064) = $87,500.

Therefore, it is in the best interests of Whitby not to call the debt since the annual interest rate penalty
exceeds the annual interest rate savings.

21.14 The company should refund when the NPV of refunding is greater than zero, so we need to find the
interest rate that results in a zero NPV. The NPV of the refunding is the difference between the gain
from refunding and the refunding costs. The gain from refunding is the bond value times the difference
in the interest payments, discounted to the present value. We must also consider that the interest
payments are tax deductible, so the aftertax gain is:

NPV = PV(Gain) – PV(Cost)

The present value of the gain will be:

Gain = [$170,000,000 × (0.08 – r) × (1 – 0.39)]/[r × (1 – 0.39)]

Since refunding would cost money today, we must determine the aftertax cost of refunding, which will
be:

Aftertax cost = $170,000,000 × 0.12 × (1 – 0.39)

Aftertax cost = $12,444,000

So, setting the NPV of refunding equal to zero, we find:

0 = –$12,440,000 + [$170,000,000 × (0.08 – r)]/r

r = 0.07454 or 7.454%

Any interest rate below this will result in a positive NPV from refunding.

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21.15 a. The price of the bond today is the present value of the expected price in one year. So, the price of the
bond in one year if interest rates increase will be:
58
P1 = $40 × A0.05 + $1,000/(1+0.05)58
P1 = $811.80

If interest rates fall, the price if the bond in one year will be:
58
P1 = $40 × A0.03 + $1,000/(1+0.03)58
P1 = $1,273.31

Now we can find the price of the bond today, which will be:

P0 = [0.50 × $811.80 + 0.50 × $1,273.31]/1.0352

P0 = $973.24

For students who have studied term structure, the assumption of risk-neutrality implies that the
forward rate is equal to the expected future spot rate.

b. If the bond is callable, then the bond value will be less than the amount computed in part a.
If the bond price rises above the call price, the company will call it. Therefore, bondholders will not
pay as much for a callable bond.

21.16 In this case, we need to find the NPV of each alternative and choose the option with the highest NPV,
assuming either NPV is positive. The NPV of each decision is the gain minus the cost. So, the NPV of
refunding the 7 percent perpetual bond is:

Bond A:

Gain = [$125,000,000 × (0.07 – 0.0625)]/0.0625

Gain = $15,000,000

Note that the gain can be calculated using the pretax or aftertax cost of debt. If we calculate the gain
using the aftertax cost of debt, we find:

Aftertax gain = {$125,000,000 × [0.07 × (1 – 0.35) – 0.0625 × (1 – 0.35)]}/[0.0625 × (1 – 0.35)]

Aftertax gain = $15,000,000

Thus, the inclusion of the tax rate in the calculation of the gains from refunding is irrelevant.

The aftertax cost of refunding this issue is:

Cost = $125,000,000 × 0.075 + $11,500,000 × (1 – 0.35)

Cost = $16,850,000

The NPV of refunding this bond is:

NPV = –$16,850,000 + $15,000,000

NPV = –$1,850,000
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 The NPV of refunding the second bond is:

Bond B:

Gain = [$132,000,000 × (0.08 – 0.0710)]/0.0710

Gain = $16,732,394.37

The aftertax cost of refunding this issue is:

Cost = $132,000,000 × 0.085 + $13,000,000 × (1 – 0.35)

Cost = $19,670,000

The NPV of refunding this bond is:

NPV = –$19,670,000 + $16,732,394.37

NPV = –$2,937,605.63

So, both bonds should not be refunded.

21.17 Bonds with an S&P’s rating of BB or below or a Moody’s rating of Ba or below are called junk bonds
(or below–investment grade bonds). The recent controversies of junk bonds are:
i. Junk bonds increase the firm’s interest deduction.
ii. Junk bonds imply high leverage, which increases the possibility of default in economic downturns.
iii. The recent wave of mergers financed by junk bonds has frequently resulted in dislocations and loss
of jobs.

21.18 a. For a floating rate bond, the coupon payments are adjustable. The adjustments are usually tied to an
interest rate index.

b. Deep discount bonds are also called pure discount bonds or zero coupon bonds. As the latter name
implies, these bonds do not pay a coupon. To generate a return, these bonds are sold at prices well
below par, since the price is the PV of the lump sum maturity value.

c. Income bonds are similar to conventional bonds, except their coupon payments are tied to the firm’s
income. The bondholders are paid only if the firm generates enough income to do so. These bonds
are attractive for firms to issue because if the firm cannot make an interest payment, it is not in
default.

21.19 a. Yes. The statement is true. In an efficient market, the callable bonds will be sold at a lower price
than that of the non–callable bonds, other things being equal. This is because the holder of callable
bonds effectively sold a call option to the bond issuer. Since the issuer holds the right to call the
bonds, the price of the bonds will reflect the disadvantage to the bondholders and the advantage to
the bond issuer (i.e., the bondholder has the obligation to surrender their bonds when the call option
is exercised by the bond issuer.)

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b. As interest rate falls, the call option of the callable bonds are more likely to be exercised by the bond
issuer. Since the non–callable bonds do not have such a drawback, the value of the bond will go up
to reflect the decrease in the market rate of interest. Thus, the price of non–callable bonds will move
higher than that of the callable bonds.

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MINI-CASE: Financing the Expansion of East Coast Yachts with a Bond Issue

1. A rule of thumb with bond provisions is to determine who the provisions benefit. 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. 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.

b. 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.

c. 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.

d. A provision with a specific call dates and prices would increase the coupon rate. The call provision
would only be used when it is to the company’s advantage, thus the bondholders’ 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.

e. A deferred call would reduce the coupon rate relative to a call provision with no 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.

f. A Canada plus 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 Canada plus 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 Canada plus call 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.

g. 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.

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 h. 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 on the company’s
actions.

i. 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.

j. The downside of a floating rate coupon is that if interest rates rise, the company has to pay a higher
interest rate. However, if interest rates fall, the company pays a lower interest rate.

k. Credit rating agencies can facilitate firm access to bond markets. An unrated bond may not attract
interest from potential investors because of the information asymmetry that may exit between the
issuing firm and investors. A bond rating can help mitigate this problem. Further, the better the
rating is , the lower the coupon rate will be, because a higher rating would indicate a lower default
risk.

2. The price of 25-year, 6% coupon bond when it is issued will be:

50
P0 = $30 × A0.035 + $1,000/(1+0.035)50 = $882.72

So, the number of Coupon bonds to sell = $40,000,000/$882.72 = 45,315

The price of the 25–year, zero coupon bond when it is issued will be:

Zero coupon price = $1,000/1.0725 = $184.25

So, the number of zero coupon bonds the company will need to sell is:

Zero coupon bonds to sell = $40,000,000/$184.25 = 217,096

3. At maturity, the principal payment for the coupon bonds will be:

Coupon bond principal payment at maturity = 45,315 × $1,000 = $45,315,000

The principal payment for the zero coupon bonds at maturity will be:

Zero coupon bond payment at maturity = 217,096 × $1,000 = $217,096,000

4. One of the main considerations is timing of the cash flows. The annual coupon payment on the coupon
bonds will be:

Annual coupon bond payments = 45,315 × $1,000 × 0.06 = $2,718,900

Since the interest payments are tax deductible, the after-tax cash flow from the interest payments will be:

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 After-tax coupon payments = $2,718,900 × (1 – 0.38) = $1,685,718

Even though interest payments are not actually made each year, the implied interest on the zero coupon
bonds is tax deductible. The value of the zero coupon bonds next year will be:

Value of zero in one year = $1,000/1.0724= $197.15

So, the growth on the zero coupon bond was:

Zero coupon growth = $197.15 – $184.25 = $12.90

This increase in value is tax deductible, so it reduces taxes even though there is no cash flow for interest
payments. So, there is a positive cash flow created next year in the amount of:

Zero cash flow = 217,096 × $12.90 × 0.38 = $1,064,204.59

This cash flow will increase each year since the value of the zero coupon bond will increase by a greater
dollar amount each year.

5. If the Treasury rate is 5.20 percent, the make whole call price in 9 years is:
32
P = $30 × A0.02825 + $1,000/(1 + 0.02825)32
P = $1,036.55

And, if the Treasury rate is 7.70 percent, the make whole call price in 9 years is:
32
P = $30 × A0.04075 + $1,000/(1 + 0.04075)32
P = $809.68

6. The investor is not necessarily made whole with the Canada plus call provision, but is made close to
whole. Assume a company issues a bond with a Canada plus call provision of the Treasury rate plus 0.5
percent. Further assume this is the correct average spread for the company’s bond over the life of the
bond. Although the spread is correct on average, it is not correct at every specific time. The spread over
the Treasury rate varies over the life of the bond, and is higher when the bond has a longer time to
maturity. To see this, consider, at the extreme, the spread for any bond above the Treasury yield at
maturity is zero. So, if the bond is called early in its life, the spread above the Treasury is likely to be too
low. This means the investor is more than made whole. If the bond is called late in its life, the spread is
too high. This means the interest rate used to calculate the present value of the cash flows is too high,
which results in a lower present value. Thus, the bondholder is made less than whole. In practical terms,
this difference is likely to be small and will almost always result in a higher price paid to the bondholder
when compared to a traditional call feature.

7. There is no definitive answer to which type of bond the company should issue. If the intermediate cash
flows for the coupon payments will be difficult to make, a zero coupon bond is likely to be the best
solution. However, the zero coupon bond will require a larger payment at maturity.

As for the type of call provision, Canada plus call provision is generally better for bondholders, therefore
the coupon rate of the bond will likely be lower to sell the bond at par value. Again, there is a tradeoff.
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