Tutorial 10-2

Question 1

The Kristie Lance Company Pty Ltd would like to take advangtage of $5 million of positive NPV projects. What long-term financing strategy would you suggest Kristie Lace should use?

Answer 1

Kristie Lace should use internal funds within the constraint of requiring sufficient working capital. It should then look at establishing a debt/equity ratio that is acceptable in the industry. Because debt provides a tax subsidy so that VL = VU + tcD it should push its debt level to a maximum. If the debt level is too high, the market will require an interest rate that the company cannot afford, substantially increasing the bankruptcy risks.

Question 2

Plane Aero Ltd has decided to float a perpetual debenture issue. The current interest rate is 8%. In one year, there is an even chance that interest rates will be 5% or 20%. Will this issue sell for par if the coupon is $8? What would it sell for if the coupon were $10

Answer 2

Coupon is $8:

Expected price in 1 year = 0.5(8/0.05) + 0.5(8/0.20) = $100
P0 = (8 + 100)/1.08 = $100

Coupon is $10:

Expected price in 1 year = 0.5(10/0.05) + 0.5(10/0.20) = $125
P0 = (10 + 125)/1.08 = $125

Question 3

What is the effect of each of the following provisions on the coupon rate for a newly issued debenture? Give a brief explantion in each case:

a/ A call provision

Answer 3

Increases yield; investors require a higher return for the risk of the bond being called before maturity

Question 4

What is the effect of each of the following provisions on the coupon rate for a newly issued debenture? Give a brief explantion in each case:

b/ A convertibility provision

Answer 4

Decreases yield; investors require a lower return because they have an option to convert

Question 5

What is the effect of each of the following provisions on the coupon rate for a newly issued debenture? Give a brief explantion in each case:

c/ A put provision

Answer 5

Decreases yield; investors require a lower return because they have the option of forcing the company to buy back the bond early.

Question 6

What is the effect of each of the following provisions on the coupon rate for a newly issued debenture? Give a brief explantion in each case:

d/ A floating coupon

Answer 6

Probably decreases the yield, but it depends on what the coupon is tied to.