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Flashcards in Tutorial 10-2 Deck (6)
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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?

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.

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

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

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

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

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

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

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

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

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

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