Mini Case Chapter 8

1. Describe effect on coupon rate as well as advantages/disadvantages of the following bond

features.

a. Security of the Bond (-> Collateral)

A collateral generally lowers the coupon rate as it represents the security of the bond, and
thus the investor needs to be compensated less for the lower risk he/she is taking. The fact
that it lowers the coupon rate is advantageous for the issuer company. However, the issuer
needs to hold the asset that they pledged as collateral so that the investor can claim it,
restricting the issuer's actions (e.g., it is not possible to sell the asset for the time being; this
can also be included as a negative covenant, see below).

b. Seniority
The seniority of a bond indicates the order of bondholders who will be repaid first in the case
of bankruptcy of the issuer. Naturally, a higher seniority reduces the risk and thus the
coupon rate, which is advantageous for the issuer. However, it restricts the issuer as when
they give out many high seniority bonds early, they cannot give out many more high seniority
bonds in the future as the order is already set. Therefore, seniority is a somewhat limited
tool.

c. Sinking Fund
A sinking fund can be seen as money paid by the issuer to a trustee with the sole intention of
paying off bond issues by purchasing bonds in the open market. It also represents a security
feature for bondholders and reduces the coupon rate. The disadvantage of a sinking fund is
obvious, as the issuer has to make ongoing payments into the fund in order to finance it.

d. A Call Provision with specified Call Dates and Call Prices

With a call provision in place, the issuer has the opportunity to repurchase and retire a bond
before maturity. It can be seen as more of a safety option for the issuer of the bond, as they
will only use the call provision when it is worth it for them. Therefore, it raises the coupon
rate. For the issuer, it is an advantage to have a call provision in place when interest rates
fall and they want to restructure the financing of their debts. However, if they want to include
a call provision in the bond, they will have to pay a higher coupon rate.

e. A Deferred Call accompanying the Call Provision

The option of a deferred call means that the issuer can only make use of the call provision
after a certain date. Relative to the call provision in d., it lowers the coupon rate as it is a
security feature for bondholders. The disadvantage is obvious, as it restricts the firm's
opportunity to make use of the call provision at an earlier date.

f. A make-whole Call Provision

A make-whole call provision allows the issuer to pay the NPV of the remaining (coupon)
payments early. It lowers the coupon rate relative to the call provision in (d), and with this
option, the investor receives the NPV of all future cash flows. This feature is usually
implemented when interest rates are falling and protects investors from having to reinvest at
a lower interest rate. As there are no real advantages for the issuer (compared to d.), make-
whole call provisions are rarely implemented in reality, unless the issuer desperately wants a
call provision that does not increase the coupon rate too much.

g. Positive Covenants
Positive covenants include certain requirements the issuer company has to fulfill in order to
guarantee its financial health and stability. They are another security feature for the
bondholders and lead to a reduction of the coupon rate. Examples of positive covenants are
restrictions on certain financial ratios that indicate solvency, a common indicator being
debt/(EBIDTA minus capital expenditure). Also, it can include requirements for ratios
indicating profitability, such as net earnings/net sales. Furthermore, positive covenants may
include the requirement to give bondholders audited financial statements and to maintain a
reasonable level of insurance. They can be an effective tool to lower the coupon rate, as
they include requirements that the issuer company often fulfills anyway. However, an
obvious disadvantage is that the firm restricts its actions, even in some extreme situations in
which the company would be better off not meeting certain requirements (e.g., for solvency
ratios).

h. Negative covenants
Negative covenants prevent the bond issuer from taking certain actions, such as selling the
issuing company or merging it with another company. In contrast to positive covenants, this
can be seen as a pledge not to do something (compared to a guarantee to fulfill certain
requirements/take certain actions). Of course, it is closely connected to positive covenants
and can thus also reduce the coupon rate. An example of a negative covenant is to not
increase dividends to a specified level and thus limit dividend payments. As East Coast
Yachts is not publicly traded, this is not an option for them; however, there are several other
negative covenants that East Coast Yachts might consider. For example, the company could
decide to implement a restriction on issuing more debt. Also, they could guarantee not to sell
any collateral.

i. A Conversion Feature
A convertible bond usually means that a bond may be converted into a specified quantity of
the issuer company’s common stock. Therefore, as East Coast Yachts is not publicly traded
and therefore has no stocks that the bond could be converted into, they cannot implement a
convertible bond. However, there is another option for private companies to implement such
a conversion feature. Usually, bondholders are permitted ownership in the issuing company
if it fails to pay any of the required bond payments. As this is another form of protecting the
investor, it lowers the coupon rate. The main disadvantage of this feature is that possibly
giving up partial ownership is a high price to pay for adding a little bit more security, which is
why there are likely better options for East Coast Yachts to lower the coupon rate.

j. A Floating Rate Coupon

A floating rate coupon implies, as the name states, that the bond has a fluctuating coupon
rate and thus also fluctuating coupon payments. The coupon rate is tied to a benchmark
rate. Of course, the effect on the coupon rate then depends on whether the interest rate
rises or falls. Also, this feature usually includes a ceiling and floor, i.e., a minimum and a
maximum interest rate. As this is sort of a shaky feature, the advantages and disadvantages
are evident. For a rising interest rate, the company would have to make higher coupon
payments compared to a fixed rate bond. However, if the gamble pays off, the company can
save some of the coupon payments it would have had to pay for a fixed rate bond.

2. Dan is considering whether to issue coupon-bearing bonds or zero coupon bonds. The
YTM on either bond issue will be 5.8 percent. The coupon bond would have a 5.8 percent
coupon rate. The company's tax rate is 21 percent. How many of the coupon bonds must
East Coast Yachts issue to raise the $60 million? How many of the zeroes must it issue?

Coupon-bearing bond

If the company wants to raise $60 million, the total market value of bonds should equal to
$60 million, which means that the present value should be $60 million.

let Number of Coupon Bonds = n

19
PV = n x ∑ ❑(coupon value / (1+r)^i) +
i=1
19
60 million = n x ∑ ❑(58 / (1+5.8%)^i) + 1058 / (1+5.8%)^20
i=1
n = 60000000 / ¿(58 / (1+5.8%)^i) + 1058 / (1+5.8%)^20)
n = 60000

The company has to issue 60000 coupon bonds to raise $60 million.

For coupon bonds:（adjusted）

Price of bond = coupon x (1 - (1 + YTM)^(-n)) / YTM + par value / (1 + YTM)^n

where:

coupon = 5.8% of par value

YTM = 5.8%
n = 20 years
par value = $1,000
We know that the total amount to be raised is $60 million, so we can set the price of the
bond equal to $1,000 to solve for the number of coupon bonds:

$60,000,000 = coupon x (1 - (1 + YTM)^(-n)) / YTM + par value / (1 + YTM)^n

$60,000,000 = 58 x (1 - (1 + 0.058)^(-20)) / 0.058 + 1,000 / (1 + 0.058)^20

$60,000,000 = 1000

Number of coupon bonds = $60,000,000 / $1000per bond = 60000 bonds

Therefore, Dan needs to issue approximately 60000 coupon bonds to raise $60 million.
For zero coupon bonds:（adjusted）

Price of bond = par value / (1 + YTM)^n

where:

YTM = 5.8%
n = 20 years
par value = $1,000
Again, we can set the price of the bond equal to $1,000 to solve for the number of zero
coupon bonds:

$60,000,000 = par value / (1 + YTM)^n

$60,000,000 = $1,000 / (1 + 0.058)^20 x number of zero coupon bonds

Number of zero coupon bonds = $60,000,000 / 323.8073 = 185295.3901

Therefore, Dan needs to issue approximately 185295 zero coupon bonds to raise $60
million.

3. In 20 years, what will be the principal repayment due if East Coast Yachts issues the
coupon bonds? What if it issues the zeroes?

If East Coast Yachts issues the coupon bonds, the principal repayment due in 20 years will
be equal to the face value of each bond, which is $1,000. Therefore, the total principal
repayment due in 20 years for all the coupon bonds issued would be:

Principal repayment for coupon bonds = $1,000 x 60，000 = $60,000,000

If East Coast Yachts issues the zeros, the principal repayment due in 20 years will also be
equal to the face value of each bond, which is $1,000. Therefore, the total principal
repayment due in 20 years for all the zero coupon bonds issued would be:

Principal repayment for zero coupon bonds = $1,000 x 185295 = $185,295,000

In summary, if East Coast Yachts issues coupon bonds, the principal repayment due in 20
years would be $56,026,330, while if it issues the bonds, the principal repayment due in 20
years would be $80,384,570.

4. What are the company's considerations in issuing a coupon bond compared to a zero
coupon bond?
When deciding whether to issue a coupon bond or a zero coupon bond, a company must
consider several factors, including:

Cost of capital: If the cost of capital is high, a company may prefer to issue a zero coupon
bond to avoid paying periodic interest payments, which can reduce the overall cost of
borrowing.

Cash flow requirements: If a company has limited cash flow or expects significant capital
expenditures in the near future, it may prefer to issue a zero coupon bond to avoid making
periodic interest payments.

Market demand: The demand for coupon bonds versus zero coupon bonds may vary
depending on market conditions and investor preferences.

Credit rating: The company's credit rating can affect the cost of borrowing for both coupon
and zero coupon bonds.

Tax implications: The tax treatment of coupon versus zero coupon bonds can also be a
consideration, as coupon payments are generally subject to taxation, while zero coupon
bonds are taxed on their accreted value.

Overall, the decision to issue a coupon bond or a zero coupon bond depends on a variety of
factors, and each option has its own advantages and disadvantages.

5. Suppose East Coast Yachts issues the coupon bonds with a make-whole call provision.
The make-whole call rate is the Treasury rate plus 0.40 percent. If East Coast calls the
bonds in seven years when the Treasury rate is 4.3 percent, what is the call price of the
bond? What if the Treasury rate is 6.7 percent?

The call price of the bond is the sum of the discounted coupon payment from year seven. A
total of 14 years will be considered. When the Treasury rate is 4.3 percent:

13

∑ ❑58/(1+0.4%+4.3%)^i + 1058/(1+0.4%+4.3%)^14 = 1111.004

i=1

When the Treasury rate is 6.7 percent:

13

∑ ❑58/(1+0.4%+6.7%)^i + 1058/(1+0.4%+6.7%)^14 = 886.9876

i=1

Calculate the annual cash flows of the bond with a remaining term of N years in year n. The
annual interest cash flow is:
I = 0.058 * $1,000 = $58
P = $1,000 / 20 = $50
Therefore, the total semi-annual cash flow in year n is $108.
Assuming the call rate is r*, the present value of holding a Treasury security with the same
term is:
PV* = $108 x [1 - 1/(1+r*)^N] / r* + $1,000 / (1+r*)^N
（1）r*=4.7%
call price = 108 + 892/(1.047^N)
(2) r* = 7.1%
call price = 108 + 892/(1.071^N)

6. Are investors really made whole with a make-whole call provision?

Whether the investors really made whole depends on the Treasury rate. When the Treasury
rate is low, the yield is low, and the company has to pay more, which means the call price
will be higher than the face value, causing the make-whole provision to succeed. On the
other hand, when the Treasury rate is high, the yield is high, and the company pays less,
causing the call price to be lower than the face value, and the make-whole provision will not
succeed.

It also depends on the timing of compensation. If the redemption time is farther from the
maturity date, that is, the smaller N, the higher the call price will be, which is more beneficial
to investors; the closer the redemption time is to the maturity date, that is, the larger N, the
lower the call price, and the worse it is for investors.

7. After considering all the relevant factors, would you recommend a zero coupon issue or a
regular coupon issue? Why? Would you recommend an ordinary call feature or a make-
whole call feature? Why?

We suggest East Coast Yachts go for a zero coupon issue because it does not issue interest
to bondholders and has a higher return over a long period of time compared to a regular
coupon issue. Also, it will avoid annual cash outflow, and the company will have more
money to utilize for internal growth purposes.

Make-whole call because it allows the issuer to call the bond before it reaches the maturity
period. The issuer has the option to call the bond early by paying down the remaining
obligation. Also, the provision can be used any time during the contract’s duration.

The decision to issue either zero coupon or regular coupon bonds depends on several
factors, as previously discussed, including the company's cost of capital, cash flow
requirements, market demand, and credit rating.

If East Coast Yachts can tolerate the large upfront cost of the zero coupon bonds and has
no immediate need for periodic interest payments, then a zero coupon issue may be a good
choice. On the other hand, if the company prefers to pay interest periodically and has a
strong cash flow position, then a regular coupon issue may be more appropriate.

As for the call feature, it would depend on the company's future plans and market conditions.
If East Coast Yachts expects interest rates to decline significantly in the near future, a make-
whole call provision may be more advantageous. This would allow the company to refinance
the bonds at a lower rate without incurring significant penalties.
However, if the company expects interest rates to rise or remain stable, an ordinary call
feature may be more appropriate, as it would allow the company to redeem the bonds at a
predetermined price without having to pay additional premiums. Ultimately, the decision to
include a make-whole call provision or an ordinary call feature would depend on the
company's specific circumstances and market conditions at the time of issuance.