Question

Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $50 million in new 20-year bonds to finance new construction. Dan has entered into discussions with Kim McKenzie, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue.

1. You are Kim’s assistant, and she has asked you to prepare a memo to Dan 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.

The security of the bond, that is, whether or not the bond has collateral.

The seniority of the bond.

The presence of a sinking fund.

A call provision with specified call dates and call prices.

A deferred call accompanying the above call provision.

A make-whole call provision.

Any positive covenants. Also, discuss several possible positive covenants East Coast Yachts might consider.

Any negative covenants. Also, discuss several possible negative covenants East Coast Yachts might consider.

A conversion feature (note that East Coast Yachts is not a publicly traded company).

A floating rate coupon.

Answer 1

Here is the answer for the majority of the features:

Bond feature	Impact on coupon rate	advantages	disadvantages
security	lower coupon rate	lower interest expense; also as the bond is more attractive due to the security, it should be easier for the company to find buyers	the risk of losing the collateral in the extreme case of default; lower tax advantage
seniority	lower coupon rate	lower interest expense	a collateral is required
presence of a sinking fund	higher coupon rate	flexibility as the company issuing the bond could pay in advanced installments; therefore, implies less interest expense	the money that needs to be destined to the payments for the fund could not be used for other purposes. This might mean higher opportunity costs
call provision with specified call dates and call prices	higher coupon rate	the company has the right to buy back its bonds at a specific date and at a specific price which facilitates the planning	higher interest expense
floating rate coupon	varies in accordance with the referenced interest rates	might pay less interest if the rate the bonds are linked to goes down	the volatility of the rates implies uncertainty and, thus, higher risk and a tougher planning
conversion feature	lower coupon rate	lower interest expense	if the bond holder decides to convert it into shares, the company will have more ownership claims