Question

To fund some of its expansion plans, Ohio Rubber & Tire (ORT) recently issued 30-year bonds with low coupon rates. Investors were willing to purchase the bonds despite the low coupon rates because ORT’s debt has consistently been rated AAA during the past decade, which means that bond rating agencies consider the company’s default risk to be extremely low.

Now ORT is considering raising additional funds by issuing new debt. The company plans to use the new funds to finance additional expansion. Unlike its previous expansion efforts, however, ORT now plans to grow the firm by purchasing young firms that just “went public” that are not in the tire and rubber industry.

Wally, who works closely with ORT’s investment banker, has been assigned the task of determining how to best raise the desired funds. After speaking with the investment banker, some friends who work at other companies, and peers in ORT’s international subsidiaries, Wally is seriously considering recommending to management that ORT issue a new security that has the characteristics of both debt and equity. The security, which was recently introduced in the U.S. financial markets, is classified as debt because fixed interest payments that are tax deductible are paid every year. Unlike conventional bands, however, these hybrid bonds, which are called “boondocks,” have maturities of 50 to 60 years. In addition, the firm is not considered to be in default if it misses interest payments when the firm’s credit rating drops below B+. Most experts consider boondocks to be quite complex financial instruments.

Through his research, Wally discovered that boondocks have been used for quite some time outside of the Unite States. Compared with conventional debt, companies that have used boondocks have increased their earnings per share (EPS) significantly. A major reason EPS increases is because the cost of a bondock generally is much lower than equity, but the instrument is comparable to equity financing with respect to maturity and default risk. For example, Wally discovered that ORT could issue boondocks with an after-tax cost equal to 5%, which is only slightly higher than the after-tax cost of issuing conventional debt and is approximately one-third the cost of issuing new equity. Although boondocks are considered risky, the actual degree of risk is unknown. The friends and coworkers with whom Wally consulted seem to think there is a slight chance that investors—both stockholders and bondholders—would earn returns significantly lower than would be earned with conventional debt when the company performs extremely poorly. The opposite should occur when the company performs very well.

The major drawback to issuing boondocks is that they will significantly increase the financial leverage of ORT, and thus the value of the recently issued bonds will decrease substantially. On the other hand, Wally thinks that issuing boondocks can be a win-win proposition for ORT and its common stockholders. If the company’s expansion plans are unsuccessful, the market values of both its debt and its equity would decrease to the point that it would be attractive for the firm to repurchase these financing instruments in the capital markets. If this is true, then issuing boondocks would benefit stockholders at the expense of bondholders. ORT’s executives are major stockholders because their bonuses and incentives are paid in the company’s stock.

What should Wally do? What would you do if you were Wally?

Answer 1

If I was Wally, then I would not have gone for the option of issuing Boondocks. The given case shows that boondocks will have several risks and the extent of the risks is high. In case the company does not perform well then the investors in the boondocks will earn significantly low returns on their investment. Moreover, the issuing of boondocks led to incease in leverage of the company i.e. more of debt than equity. This is not a good signal about the financial condition of the company.

Wally wishes to use the money that will be raised from the boondocks for the expansion of the company but in case the company's expansion plans do not work out as expected then the stockholders as well as the bondholders will lose money. Afterwards, if the company decides to repurchase these financial instruments from the capital market then only the stockholders would benefit and the bondholders will feel cheated. This is not the right kind of practice in financial management. In terms of financial gains it may appear right but it is definitely wrong in terms of ethics. Thus, Wally should not opt for boondocks instead issuing IPO would be a better option.