Bonds Issue Financing East Coasts Expansion Plans

Running head: BONDS FEATURES

BONDS FEATURES 7

Financing East Coast’s 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 bond’s 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 protection period even when conditions are favorable, such as if interest rates are extremely low.

A make-whole call provision

A make-whole call provision is a clause on a bond that allows the issuing company to retire the bond early and then pay off outstanding debt to the bondholder (Jordan et al., 2010). The company calculates the present value of the expected cash flows from the bond to maturity, and pays the amount to the bondholder. The main advantage is that it allows the bondholder to reinvest in other comparable securities. On the downside, however, the cost to the company can be significantly high and as such, make-whole provisions are rarely invoked (Jordan et al., 2010).

Any positive covenants, and discuss several positive comments that East Coast Yacht could consider

A positive covenant is any clause that requires the issuer to meet specific requirements. A positive covenant reduces the coupon rate as it offers some form of protection to bondholders (Jordan et al., 2010). Some possible positive comments that East coast could adopt include specifications on a minimum current ratio that the company will maintain, the commitment to maintain collateral in good working condition, and the commitment to notify the bondholders in advance in the event of significant difficulty that threatens sustainability. The downside of positive comments is that they restrict the company to the commitments it makes even when facing financial difficulty (Megginson, Lucy, Smart, 2008). On the positive side, however, it reduces the interest payable on bonds, which is beneficial to the company.

Any negative covenants, and discuss several negative comments for East Coast

A negative covenant is a covenant preventing the issuer from taking certain activities unless with the bondholders’ consent (Megginson et al., 2008). They serve to protect the bondholders’ interests and are legally binding, hence causing a reduction in the coupon rate. Negative covenants could include; the company cannot sell assets placed as bond collaterals or cannot issue bonds more senior to the current bonds (Megginson et al., 2008). On the positive note, negative covenants protect bondholders and reduce interest payable on bonds. However, they restrict the company from taking certain action when experiencing financial challenges.

A conversion feature

A conversion feature allows the holder of a security to transform their current investment into another form of investment (Megginson et al., 2008). For instance, East Coast is not a public company but has an opportunity to become one given the immense growth it has reported recently. A conversion feature on the issued bonds would mean that bondholders would be allowed to transform their bonds into common stock or other security (Megginson et al., 2008). Thus, conversion features lower the risk of loss, consequently reducing the coupon rate. On the downside, however, the feature could be costly, especially if the company is issuing equity at a low price (Megginson et al., 2008).

A floating rate coupon

A floating rate coupon is a coupon rate that fluctuates or varies with the rate of interest throughout the period. If the rate of interest increases, the company has to pay a higher interest on its bonds, and if interest rates fall, it pays a lower interest on its bonds (Megginson et al., 2008). Thus, the interest payable with bonds issued on a floating rate coupon is unpredictable.

2. How many of the coupon bonds must East Coast Yacht issue to raise the $45 million? How any of the zeroes must it issue?

a) If it issues coupon bonds;

We need to first calculate the price of the bonds to determine how many bonds need to be issued:

For coupon bonds, YTM where t is years to maturity, c is the coupon payment, p is the price of the bond, FV is the face value of the bond.

The rule of thumb is that if The YTM is equal to the bond’s coupon rate, the bond is selling at par, and the FV is equal to the price of the bond (Gallagher & Andrew, 2007). In this case, the coupon rate and YTM are both equal to 5.5, implying that the bond is selling at par.

We assume FV to be $1,000 (a common face value for bonds), which implies then that the market price of the bond (p) is $1,000

The number of coupon bonds to be issued is given by:

= 45,000 coupon bonds

b) If it issues zeroes

The YTM for a zero-coupon bond is given by: