Question

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 $20 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, 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 as to the costs and benefits of some features, so he isn't clear on 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 also like you to list any advantages or disadvantages of each feature.

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

b. The seniority of the bond.

c. The presence of a sinking fund.

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

e. A deferred call accompanying the preceding call provision.

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

g. A floating rate coupon.

Answer 1

A) If the bond has collateral, it means that the bond is less risky than a bond without collateral and so the coupon rate will be low for the bond with collateral.

Coupon rate is a amount which investor or bond holder recieves at regular time interval from the bond seller until the bond matures.

2. Seniority of bond: A bond can be classified based on the seniority. This means when a bond defaults high senior bond recieves the repayment first . So this has low risk than junior bonds. Senior bonds coupon rate will be lower than the junior bonds coupon rate.

3. Sinking funds means that the issuer is keeping some amount regularly aside to pay back a portion of the bond and buy it back. This adds safety to the bond holder. And so the coupon rate will be less for sinking funds bond.

4. Callable bond gives safety to the issuer of the bond. Callable features allows the bond issuer to buy back the bond at the callable date. So callable bond have higher yields compared to the non callable bonds. So the coupon rate will also be higher.

e) deferred call provision allows the bond issuer not to call the bond until certain date. And so the bond is protected from calling for certain period of time which is advantage to the bond holder. This will reduce the coupon rate compared to the callable bond.

f) conversion feature allows the buyer of the bond to convert this bond to stocks. This is issued by the issuer mainly to lower the coupon rate of the bond.

G) This gives flexibility to the coupon rate. Here the coupon can increase of decrease based on the market rate tied with the bond.