Mark Sexton and Todd Story

FIN 6130: Individual Assignment (case study) Case Study: Mark Sexton and Todd Story, the owners of a manufacturing company have decided to expand their operations. They instructed you as their newly hired financial analyst to enlist an underwriter to help sell $35 million in new 10-year bonds to finance construction. You have entered into discussion with Kim McKenzie, an underwriter from the firm of Raines and Warren about which bond features your company should consider and what coupon rate the issue will likely have.

Although your Bosses are aware of the bond features, they are not sure about the costs and benefits of some features especially how they will affect the coupon rate of the bond issues. This is more so that your firm is not a publicly traded company. You have been asked to prepare a memo on the effect of each of the following bond features on the coupon rate of the bond. It is expected that you will emphasis on their perceived benefits. The bond issuer/the borrower/the bosses: Mark Sexton and Todd Story Bond value: $35 million Bond maturity: 10 years Financing purpose: construction

Hired underwriter: Kim McKenzie (Raines and Warren) .Case Studied Memos: 1. The security of the bond- that is, whether the bond has a collateral. Secured bond is with collateral, whereby the issuer pledged specific assets in case of bankruptcy or unable to pay debt. A bond with collateral will have a lower coupon rate (interest/return) and lower the security’s risk but with higher credit ratings, which less likely it is to default. But the issuer need to ensure that the collateral is in good working order and cannot be sold until the bond is matured.

Considering bond with collateral is secured investment to investors, during default, the investors may receive all or part of the collateral in the value of debt unpaid. Collateralized bond is also marketable to the secondary market especially if it is a non-publicly traded or listed company recognized among investors. In term of outlining the specific security of collateral attached to a bond, it’s best to put clear guideline of what sort of asset eligible to be put as collateral and define certain rule of how the asset’s value can be sum up to secure the bond maturity period. 2.

The seniority of the bond In case of liquidation or bankruptcy, senior bond has higher priority to be paid first compared to another bond that is considered junior or the subordinated bonds. Senior bond gets full payment in bankruptcy which its covenant may restrict the borrower from issuing any future bonds senior to the current bonds. A junior bond’s security ranks lower than other bond securities in regard to the owner’s claims on assets and income if the issuer becomes insolvent. Bondholders of secured debt (with collateral) must be paid before the holders of unsecured debt.

Bondholders of unsecured debt must be paid before preferred shareholders, and finally, preferred shareholders must be satisfied before common shareholders. In general, a junior security entails greater risk but offers higher potential yields than securities with greater seniority. To be more appealing to investors, the bondholders should propose senior bond in able to offer lower coupon. 3. The presence of a sinking fund Bond sinking fund is a restricted asset where the issuer is required to set aside money for redeeming back or buying back some of its bond payable by deposited money with an independent trustee.

Sinking fund is a partial guarantee to bondholders that will reduce the coupon rate. By having sinking fund, it allows the issuer to repay specific bond’s value at a certain period or retire a portion of the bond every year until it’s matured. It’s a great program but the issuer must be able to generate cash flows to make the interim payments into a sinking fund or else, face default. By having the presence of a sinking fund as collateral support of a bond, it promotes financial security which will attract investors to accept bond with lower interest rates.

With the sinking fund, it will also gain benefits through taxation and enjoy capital gain. It also secured a good management of long-term debt in advance. 4. A call provision with specified call dates and call prices Adding provision to a bond with specific call date and prices will benefit the bond issuer more than the bondholder but it will definitely increase the coupon rate. Able to repurchase bonds before maturity (or at a specified date according to provision) is called callable bond (or redeemable bond) at a special price (not obligated).

Any future payment to the bondholder is immediately and indefinitely cancelled once the bond is called. Recalling a bond with lower the debt and is hence liberated from paying interest on the called bond. Normally, the bond is called because the issuer no longer needs to borrow the money, or because interest rates have fallen and the issuer want to issue new bonds at a lower interest rate. In security purpose of long-term benefit with uncertain financial forecast, it is not applicable to issue call provision. 5. A deferred call accompanying the call provision

A bond with call provision accompanied by a deferred call will actually prohibited from calling the bond before a certain date. It is call protected or Period of Call Protection during the period of time which the bond may not be prematurely redeemed. During the call protected period (the cushion period), coupon rate payments are guaranteed but not later. After the call date, the bond may be redeemed by returning principal to the bondholder and ceased the coupon rate. The call provision accompanied by deferred call in a bond is to protect the bondholder from the falling of interest rates before the call date.

A deferred callable bond may demand a slightly higher coupon rate compared to a normal bond due to its callable feature as investors are exposed to the reinvestment risk assuming that the prevailing interest rates then is lower than the coupon paid by our bond on the callable date. 6. A make-whole call provision A bond with a make whole call (provision) allowing the issuer to pay off remaining debt early by making lump sump payment based on NPV (net present value) of future interest payments that will not be paid in cause of the call.

This type of call should lower the coupon rate than the normal call provision with specific dates. Bondholders will receive the market value of the bond if it is a make whole provision which then they can reinvest in another bond with same criteria. The make whole call will be defined in the indenture. Normally, an issuer doesn’t expect to have to use this type of provision, but if the issuer does, investors will be compensated, or “made whole”. Because the cost can often be significant, such provisions are rarely invoked.

Hence, it is recommended that the bond issuance should not have a make-whole call provision. 7. Any positive covenants. Discuss any overall positive covenants that your firm may consider. The presences of positive covenants (also called as affirmative covenant) protect bondholders by forcing the company to undertake actions that benefit bondholders. A positive covenant would reduce the coupon rate but will increase the trust of bondholders. For instance, it requires the issuer to cover the principal of the bond; enough liquid assets must be maintained.

More commonly, a positive covenant requires the issuer to have a certain amount of insurance or submit to periodic audits. 8. Any negative covenants. Discuss any overall negative covenants that your firm may consider. A negative covenant would reduce the coupon rate. Remember, the goal of a corporation is to maximize shareholder wealth. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. This says nothing about bondholders. In example, the issuer cannot increase dividends, or at least increase dividends beyond a specified level.

The downside of negative covenants is the restriction of the issuer’s actions. 9. A conversion feature The conversion feature is a financial derivative instrument that is valued separately from the underlying security. Therefore, an embedded conversion feature adds to the overall value of the security. The conversion feature would permit bondholders to benefit if the company does well and also goes public. Even though the company is not public, a conversion feature would likely lower the coupon rate.

The downside is that the company may be selling equity at a discounted price. Convertible bond is an example of an asset that can undergo conversion. It gives the bondholder the option to exchange the bond for an amount (predetermined) of the bond issuer’s equity. Typically, the bondholder will exercise the option when the total value of the shares received from conversion exceeds the bond’s worth. 10. A floating rate coupon Floating rate coupon is a bond with floating coupon payments that are adjusted at specific intervals.

It is all known as a variable rate bond which has a floating or variable rate interest, or coupon rate. The bond is payable to the bondholder upon demand following an interest rate change. The rate adjusts according to a predetermined formula outlined in the bond’s prospectus or official statement. Generally, the current money market rate is what is used to set the interest rate (plus or minus a set percentage). As a result of this, the coupon payments can change over time. A floating rate coupon or variable rate bonds’ market values fluctuate less than other bonds.