Chapter 24 - The Many Different Kinds of Debt

CHAPTER 24
The Many Different Kinds of Debt

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. High-grade utility bonds

b. Industrial holding companies
c. Industrial bonds
d. Railroads
e. Asset-backed security

Est. Time: 01 – 05

2. a. Decreases

b. Impossible to say

c. Impossible to say. For example, if the bond has a high coupon and is sold
at a premium at issue, the prospect of drawings at par could decrease
value. For an original-issue discount bond, the effect could be reversed.

Est. Time: 01 – 05

3. a. You would like an issue of junior debt.

b. You prefer it not to do so unless you are positive the existing property will
be sufficient to pay off your debt and the new debt is junior to your debt.
Should the existing property be sufficient to pay off your debt, your
remaining balance would vie with other unsecured debt for payment.

Est. Time: 01 – 05

4. a. First Boston Corporation

b. Bank of America National Trust and Savings Association

c. $986.14

d. Registered

e. 103.0%

Est. Time: 01 – 05

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

5. a. Based on a 365-day year:

Payment = 99.489 + 8.25 × (14 / 365)

Payment = 99.805%

b. Payment = .0825 / 2 × $250m

Payment = $10.3125 million

c. After making earlier sinking fund payments, $12.5 million remains to be

repaid on Aug.15, 2022.

d. 2008

Est. Time: 01 – 05

6. Private placements: typically have simpler loan agreements—which may

nevertheless contain “custom” features; have more stringent covenants; are
more easily renegotiated; and generally carry a higher rate of interest.

Est. Time: 01 – 05

7. a. False. In the event of default, secured bonds have seniority for the
relevant assets.

b. True, but some new securities (e.g., eurobonds) survive even when the
original motive for issuing them disappears.

c. False. The borrower has the option.

d. True. But debt issues with weak covenants suffered in such takeovers.

e. True. The costs of renegotiation are less for private placements.

Est. Time: 01 – 05

8. a. $1,000 / $47 = 21.28

b. $1,000 / 50 = $20.00

c. $1,000 / $47 × $41.50 = $882.98, or 88.298% of face value

d. Equilibrium stock price = bond value in absence of conversion /

conversion ratio
Equilibrium stock price = (.65 × $1,000) / ($1,000 / $47)
Equilibrium stock price = $30.55

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

e. No (not if the investor is free to convert immediately)

f. Option value = (bond’s market price – bond’s value in absence of

conversion) / conversion ratio
Option value = (.91 – .65) × $1,000) / ($1,000 / $47)
Option value = $12.22

g. Price increase = conversion price / stock price

Price increase = ($47 / $41.50) – 1
Price increase = .1325, or 13.25%

h. The bond should be called when the market price equals the call price of
102.75% of face value.

Est. Time: 06 – 10

9. a. False. Convertible bonds are equivalent to straight bonds plus an

option to acquire common stock, which is subordinate to senior claims.
b. True
c. False. When the conversion price is increased the conversion ratio
declines, and thus the value of the convertible is lower.
d. True

Est. Time: 01 – 05

10. If the bond is issued at face value and investors demand a yield of 8.25%,
then, immediately after the issue, the price will be $1,000. As time passes,
the price will gradually rise to reflect accrued interest. For example, just
before the first (semiannual) coupon payment, the price will be $1,041.25,
and then, upon payment of the coupon ($41.25), the price will drop to $1,000.
This pattern will be repeated throughout the life of the bond as long as
investors continue to demand a return of 8.25%.

Est. Time: 01 – 05

11. Answers will vary, depending on the company chosen. Some key areas that
should be examined are: coupon rate, maturity, security, sinking fund provision,
and call provision.

Est. Time: 06 – 10

12. Floating-rate bonds provide bondholders with protection against inflation and
rising interest rates, but this protection is not complete. In practice, the extent
of the protection depends on the frequency of the rate adjustments and the

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

benchmark rate. (Not only can the yield curve shift, but yield spreads can
shift as well.)
Similarly, puttable bonds provide the bondholders with protection against an
increase in default risk, but this protection is not absolute. If the company’s
problems suddenly become public knowledge, the value of the company may
fall so quickly that bondholders might still suffer losses even if they put their
bonds immediately.

Est. Time: 01 – 05

13. The First mortgage bondholders will receive all of the proceeds from the sale
of the fixed assets up to the total amount owed. If the fixed assets are
insufficient to repay the mortgage bonds, any remaining amount due is
treated similar to the senior debentures. Thus, the distribution of assets would
be:

Amount Fixed Net working

owed assets capital Total paid
Mortgage bonds 250 200 50 250
Senior debentures 100 0 50 50
Subordinated debentures 120 0 0 0
Total 470 200 100 300

Est. Time: 06 – 10

14. If the assets are sold and distributed according to strict precedence, the following
distribution will result:

Subsidiary A Subsidiary B Parent

Assets Deb. Pref To Assets Sr. Sub. To From Assets Sr Coll
stock parent Deb. Deb. parent subs Bonds
500 320 15 220 180 60 165 80 400
Payments 320 15 165 180 40 245
Unpaid 20 155

In Subsidiary A, the $320 million of debentures and $15 million of preferred stock
will be paid with the remaining $165 million remitted to the parent. In Subsidiary
B, the $180 million of senior debentures will be paid off and $40 million of the
subordinated debentures will be paid. In the holding company, the $80 million of
real estate plus the $165 million from the subsidiaries will be paid in partial
satisfaction of the $400 million of senior collateral trust bonds.

Est. Time: 06 – 10

15. a. Typically, a variable-rate mortgage has a lower initial interest rate than a
comparable fixed-rate mortgage. Thus, you can buy a bigger house for the
same mortgage payment if you use a variable-rate mortgage. The second

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

consideration is risk. With a variable-rate mortgage, the borrower assumes

the interest rate risk (although in practice this is mitigated somewhat by
the use of caps), whereas, with a fixed-rate mortgage, the lending
institution assumes the risk. A key question with a variable-rate mortgage
is: Can you afford the payment given the highest allowable interest rate?

b. If borrowers have an option to prepay on a fixed-rate mortgage, they are

likely to do so if interest rates decrease. Of course, this is not the time that
lenders want to be repaid because they do not want to reinvest at the
lower rates. On the other hand, the option to prepay has little value if rates
are floating, so floating rate mortgages reduce the reinvestment risk for
holders of mortgage pass-through certificates.

Est. Time: 01 – 05

16. A sharp increase in interest rates reduces the price of an outstanding bond
relative to the price of a newly issued bond. For a given call price, this implies
that the value to the firm of the call provision is greater for the newly issued bond.
Other things equal, the yield of the more recently issued bonds should be
greater, reflecting the higher probability of call. Notice, however, that the
outstanding bond will probably have a lower call price and perhaps a shorter
period of call protection; these may be offsetting factors.

Est. Time: 01 – 05

17. If the company acts rationally, it will call a bond as soon as the bond price
reaches the call price. For a zero-coupon bond, this will never happen because
the price will always be below the face value. For the coupon bond, there is some
probability that the bond will be called. To put this somewhat differently, the
company’s option to call is meaningless for the zero-coupon bond, but has some
value for the coupon bond. Therefore, the price of the coupon bond (all else
equal) will be less than the price of the zero, and, hence, the yield on the coupon
bond will be higher.

Est. Time: 01 – 05

18. a. Refer to Figure 24.3 in the text. Assuming the straight bond is selling at a
premium, we can see that, if interest rates rise, the derease in the price of
the straight (noncallable) bond will be greater than the change in the price
of the callable bond.
b. On that date, it will be in one party’s interest to exercise its option, and
the bonds will be repaid.

Est. Time: 01 – 05

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

19.
Value of Puttable Bond

Puttable bond

100

Straight bond

0
100 Value of
Straight Bond

Est. Time: 06 – 10

20. Allowable debt increase = net tangible assets / 2 – outstanding debt

Allowable debt increase = $250m / 2 – $100m
Allowable debt increase = $25 million

Est. Time: 01 – 05

21. a. There are two primary reasons for limitations on the sale of company
assets. First, coupon and sinking fund payments provide a regular check
on the company’s solvency. If the firm does not have the cash, the
bondholders would like the shareholders to put up new money or default.
But this check has little value if the firm can sell assets to pay the coupon
or sinking fund contribution. Second, the sale of assets in order to reinvest
in more risky ventures harms the bondholders.
b. The payment of dividends to shareholders reduces assets that can be
used to pay off debt. In the extreme case, a dividend that is equal to the
value of the assets leaves bondholders with nothing.
c. If the existing debt is junior, then the original debtholders lose by having
the new debt rank ahead of theirs. If the existing debt is senior, then the
issuance of additional senior debt means that the same amount of equity
supports a greater amount of debt; i.e., the firm’s leverage has increased,
and the firm faces a greater probability of default. This harms the original
debtholders.

Est. Time: 06 – 10

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

22. a. Conversion number of shares = ($1,000 / $25) = 40

Conversion value = 40 × $30 = $1,200

b. A convertible sells at the conversion value only if the convertible is certain

to be exercised. You can think of owning the convertible as equivalent to
owning a bond plus an option to buy the shares. The price of the
convertible bond exceeds the conversion value by the value of this call.
Also, if the interest on the convertible exceeds the dividends on 40 shares
of common stock, the convertible’s value reflects this additional income.

c. Yes. When Surplus calls, the price of the convertibles will fall to the
conversion value. That is, bondholders will be forced to convert in order to
escape the call. By not calling, Surplus is handing bondholders a “free gift”
worth 25% of the bond’s face value [i.e., (130 − 105) / 100], at the
expense of the shareholders.

Est. Time: 06 – 10

23. a. Straight-bond value = $1,000 / (1 + .08 / 2)20

Straight-bond value = $456.39

Conversion value = 10 × $50

Conversion value = $500

You would convert. By converting, you could sell the shares for $500 and
buy a straight-bond for $456.39.

b. Option value = bond price – straight-bond value

Option value = $550 – 456.39
Option value = $93.61

c. Straight-bond valueYear 1 = $1,000 / (1 + .08 / 2)18

Straight-bond value = $493.63

Bond value = straight-bond value + option value

Bond value = $493.63 + 93.61
Bond value = $587.24

Est. Time: 06 – 10

24. a. Conversion price = $1,000 / 27

Conversion price = $37.04

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

b. Conversion value = 27 × $47

Conversion value = $1,269

c. The bond is close to maturity. Thus, you should convert because the
conversion value exceeds the maturity value.

Est. Time: 06 – 10

25. a. Assuming annual compounding:

$1,000 = $532.15 × (1 + r)15

r = .0430, or 4.30%

b. Straight-bond value = $1,000 / 1.1015

Straight-bond value = $239.39

Option value = bond price – straight-bond value

Option value = $532.15 – 239.39
Option value = $292.76

c. Initial conversion value = 8.76 × $50.50

Initial conversion value = $442.38

d. Initial conversion price = $532.15 / 8.76

Initial conversion price = $60.75

e. 2005 call price = $603.71 × 1.0436

2005 call price = $777.20

2005 conversion price = 2005 call price / conversion ratio

2005 conversion price = $777.20 / 8.76
2005 conversion price = $88.72

The increase in the conversion price reflects the accreted value of the
bond since it has a zero coupon.

f. Yes; If investors act rationally, they should put the bond back to Marriott
as soon as the market price falls to the put exercise price.

g. 2006 call price = $603.71 × 1.0437

2006 call price = $810.62

Yes; Marriott should call the bonds if the market price is greater than
$810.62.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

Est. Time: 11 – 15

26. Number of bonds = $5,000,000 / $1,000 = 5,000

Diluted number of shares = 3,000,000 + (5,000 × 200) = 4,000,000

a. Bond value = $30,000,000 / 4,000,000 × 200 = $1,500

b. Bond value = $4,000,000 / 5,000 = $800

c. Bond value = $20,000,000 / 4,000,000 × 200 = $1,000

d. Bond value = $5,000,000 / 5,000 = $1,000

27. The existing bonds provide $30,000 per year for 10 years and a payment of
$1,000,000 in the tenth year. Assuming that all bondholders are exempt from
income taxes, the market value of the bonds is:

$30,000 $30,000 $30,000 $1,000,000

PV = + 2
+L+ + = $569,880
1.10 1.10 1.10 10 1.10 10

Thus, the debt could be repurchased with a payment of $569,880 today.

From the standpoint of the company, assuming a tax rate of 35%, the cash
outflows associated with the bonds are $1,000,000 in the tenth year and $30,000
per year, less annual tax savings of (.35 × $30,000) = $10,500. Therefore, the net
cash outflow is ($30,000 – 10,500) = $19,500 per year. To calculate the amount
of new 10% debt supported by these cash flows, discount the after-tax cash
flows at the after-tax interest rate (6.5%):

$19,500 $19,500 $19,500 $1,000,000

PV = + 2
+L+ + = $672,908
1.065 1.065 1.065 10 1.065 10

In other words, the value of these bonds to the firm is $672,908 and the market
value of the bonds is $569,880. The firm could repurchase the bonds for
$569,880 and then issue $672,908 of new 10% debt that would require cash
outflows with a present value equal to that of the original debt. The firm could
also, of course, immediately pocket the difference ($103,028).

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

Now suppose that bondholders are subject to personal income taxes. High-
income investors (i.e., those in high-income tax brackets) will favor low-coupon
bonds and will bid up the prices of those bonds. If the low coupon bonds are
worth more to the high-income investor than they are to Dorlcote, then Dorlcote
should not repurchase the bonds. (Note that, if Dorlcote issued the 3% bonds at
face value and then repurchases the bonds for $569,880, the company will be
liable for taxes on the gain.)

Est. Time: 11 – 15

28. a. For the safe project:

Lender’s payoff = (.4 × $7 million) + (.6 × $7 million) = $7 million

Ms. Blavatsky’s payoff = (.4 × $5.5 million) + (.6 × $1 million) = $2.8 million

b. For the risky project:

Lender’s payoff = (.4 × $7 million) + (.6 × $5 million) = $5.8 million

Ms. Blavatsky’s payoff = (.4 × $13 million) + (.6 × $0 million) = $5.2 million

Thus, the lender will want Ms. Blavatsky to choose the safe project while
Ms. Blavatsky will prefer the risky project.

Suppose now that the debt is convertible into 50% of the value of the firm.

For the safe project:

Lender’s payoff = {.40 × MAX[$7 million, (.50 × $12.5 million)]} + {.60 ×

MAX[$7 million, (.50 × $8 million)]}
Lender’s payoff = .40 × $7 million + .60 × $7 million
Lender’s payoff = $7 million

For the risky project:

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

Lender’s payoff = {.40 × MAX[$7 million, (.50 × $20 million)]} + {.60 ×

MAX[$5 million, (.50 × $5 million)]}
Lender’s payoff = .40 × $10 million + .60 × $5 million
Lender’s payoff = $7 million

With this arrangement the lender receives the same expected payoff (i.e.,
$7 million) from each of the two projects.

Est. Time: 11 – 15

29. The existing shareholders will be harmed by the issue of convertible bonds
because the conversion provision will be worth more than the convertible holders
pay for it. The new convertible holders will gain less than new shareholders
would gain, however. This can be seen by considering the convertible as the
stock plus a put option. In general, if the stock is truly underpriced, the existing
shareholders are better off issuing the safest possible asset; this prevents the
new holders of the asset from sharing the rewards of an increase in stock value
when an increase in new information becomes known.
The one exception to this result may occur when common stock is undervalued
because investors overestimate the firm’s risk. Remember that options written on
risky assets are more valuable than options written on safe ones. Thus, in this
case, investors may overvalue the conversion option, which may make the
convertible issue more attractive than a stock issue.

Est. Time: 06 – 10

Answers to Appendix Problems

1. Project finance makes sense if the project is physically isolated from the parent,
offers the lender tangible security, and involves risks that are better shared
between the parent and others. The best example is in the financing of major
foreign projects, where political risk can often be minimized by involving
international lenders.

Est. Time: 06 – 10

2. The advantages of setting up a separately financed company for Hubco stem

primarily from the attempt to align the interests of various parties with the
successful operation of the plant. For example, the construction firm was also a
shareholder in order to ensure that the plant would run according to
specifications. By making it a separate entity, Hubco could also enter into

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 24 - The Many Different Kinds of Debt

contractual agreements without the need to gain approval from a parent

company. Similarly, if Hubco failed, then no assets beyond the projects’ assets
could be attached. Independence also allowed Hubco to design contracts with
suppliers, customers, and funding sources to meet specific needs and/or
concerns.

Est. Time: 06 – 10

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.