Question

Financing S&S Air's Expansion Plans with a Bond Issue

Mark Sexton and Todd Story, the owners of S&S Air, have decided to expand their operations. They instructed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $35 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Raines and Warren, about which bond features S&S Air should consider and what coupon rate the issue will likely have. Although Chris is aware of the bond features, he is uncertain about the costs and benefits of some features, so he isn't sure how each feature would affect the coupon rate of the bond issue. You are Renata's assistant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond features on the coupon rate of the bond. She would like you to list any advantages or disadvantages of each feature.

1. The security of the bond-that is, whether the bond has collateral.

2. The seniority of the bond.

3. The presence of a sinking fund.

4. A call provision with specified call dates and call prices.

5. A deferred call accompanying the call provision.

6. A make-whole call provision.

7. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider.

8. Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider.

9. A conversion feature (note that S&S Air is not a publicly traded company).

10. A floating-rate coupon.

Answer 1

1-The security of the bond—that is, whether the bond has collateral.

The Effects on a bond with collateral will have a lower coupon rate because thebondholder does not want to take the risk since there are specific assets tied to the bond.

Advantages: Collateral provides assets that bondholders can claim, which can eitherlower the risk of default or have no payments at all.

Disadvantages: The company cannot sell the assets used as collateral, and they shouldkeep the assets in good working order.

Thus, bonds with collateral will have lower coupon rate

2. The seniority of the bond.

A bond with seniority is benefiting the bondholders as it mitigates their risk; therefore,the coupon rate will be lower.

Advantages: Seniority indicates preference in position within the investors. Debts may beseniors or juniors to show their seniority. The more senior that the bond is, the lower thecoupon rate due to higher payment priority

Disadvantages: The bond convenant may restrict the company from issuing the bond senior to the current bond.

Thus, more senior bonds will have lower coupon rates and vice versa.

3. The presence of a sinking fund.

A sinking fund is money or negotiable securities set aside for the purpose of redeeming debt. Bonds backed by a sinking fund are less likely to default on interest payments and repayment of principal. This make the invesrment safer and attractive to risk-averse investors.

Advantages: Sinking fund is that it attracts risk averse investors and the company can issue bonds at lower coupon rate.

Disadvantages: The company should make interim payments to the fund and for that purpose the company should be able to generate cashflows.

Thus, Lower will be the coupon rate if sinking fund is there.

4. A call provision with specified call dates and call prices.

A call provision is a clause in a bond's indenture granting the issuer the right to call, or buy back, all or part of an issue prior to the maturity date.

Advantages: Call provision is that the company can refinance at a lower rate if interest rates fall significantly, enough to offset the call provision cost. This will help in reducing the interest rate, effectively reducing the overall cost of the borrowing

Disadvantages: It is more cost effective to the issuer to pay the interest at the orginal rates if the interest is not fallen.

Thus, a call provision with specified call dates and call prices will results in higher coupon rate.

5. A deferred call accompanying the call provision.

A deferred call is a provision that prohibits the company from calling the bond before a certain date. During this period the bond is said to be call protected.

Advantages: The presence of deferred call accompanying a call provision will results in lowering thecoupon rate as deferred call provision will give protection to bondholders.

Disadvantages: The company could not call the bond until the end of specified period and is forced to commit to regular payments for several years. Even though the interest rate fall the company cannot get benefited from the situation.

Thus, A deferred call accompanying the call provision will results in lower coupon rate.

6. A make-whole call provision.

A make-whole call provision is a clause in a bond’s contract that allows the issuer to retire the bond early by paying off the remaining debt on the bond.

Advantages: Make whole call provision is that the bondholders receive the market value of the bond, so they can reinvest in another bond with similar characteristics

Disadvantages: The make whole call repays the bondholder the present value of the future cash flows. This should not affect the coupon rate.

Thus,a make whole call provision lower the coupon rate

7. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider.

A positive or affirmative covenant usually prescribes the condition of maintaining the operational well-being and stability of the borrowing party’s business. These bonds require the bond issuer to take certain actions, usually with the aim of protecting the investor

Advantages: The presence of positive covenants protects bondholder by forcing the company to undertake actions that benefit bondholders.

Disadvantages: The company get restricted in its actions. The positive covenant may force the company into actions in the future that it would rather not undertake.

Thus, positive coventants will lower the coupon rate.

8. Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider.

A negative covenant is an agreement that restricts a company from engaging in certain actions.

Several possible covenants that S&S might consider includes the company cannot increase dividends, or at least increase dividends beyond a specified level: the company cannot issue new bonds senior to the current bond issue; the company cannot sell any collateral.

Advantages: The negative covenants will reduce the coupon rate as it restrict the company from doing certain actions that are unfavourable to the bondholders. Thus, negative covenant brings protection to the bondholder.

Disadvantages:  It brings restriction to company's action.

Thus, the negative covenants will reduce the coupon rate

9. A conversion feature (note that S&S Air is not a publicly traded company).

Specification of the right to transform a particular investment to another form of investment, such as switching between mutual funds or converting preferred stock or bonds to common stock.

Advantages: The conversion feature would permit bondholders to benefit if the company does well and also goes public.

Disadvantages: The company may be selling equity at a discounted price.

Thus, there will be lower coupon rate if there is conversion feature

10. A floating-rate coupon.

A floating-rate coupon is the feature in which the interest rate of the security is not fixed. The interest rate fluctuates based on market conditions. Floating rate coupon bond carry lower yields than fixed notes of the same maturity. They also have unpredictable coupon payments.

Advantages: If interest rates fall, the company pays a lower interest rate.

Disadvantages: Floating rate coupon is that if interest rates rise, the company has to pay a higher interest rate.

Thus, the coupon rate is based on market conditions in case of floating rate coupon feature

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