Question

In: Finance

Your company plans to raise $100 million to finance its new two-year project by issuing new...

Your company plans to raise $100 million to finance its new two-year project by issuing new two-year bonds (with annual coupons and annual compounding). Your company and its new project are currently considered risk-free. Unfortunately, covenants in the preexisting debt issued during harder times impose restrictions on the amount of new debt. Specifically, if the face value of the new bond issue is below $100 million, your company can promise to pay an annual coupon of up to 5%. However, if the face value of the new issue is between $100 and $110 million, your company can only promise to pay an annual coupon of up to 1% on the entire issue. Your company is not allowed to issue bonds with the face value above $110 million. The zero-coupon yield curve for the next two years is as follows:

Year

Rate

1

5%

2

6%

Will your company be able to finance this new project?

a.

My company will be able to raise $100.00 million and will finance the project.

b.

My company will be able to raise $99.93 million and will not finance the project.

c.

My company will be able to raise $98.21 million and will not finance the project.

d.

My company will be able to raise $101.82 million and will finance the project.

e.

My company will be able to raise $98.17 million and will not finance the project.

Solutions

Expert Solution

In this case we will calculate price of bond (ie present value of all cash flow) using spot rates (zero curve).

Alternative 1: If the face value of the new bond issue is below $100 million.

As the bond will pay annually 5%, the bond will have following cash flows.

Year 1 = $5 (100*5%)

Year 2 = $100+ $5 (100*5%)

Spot Rate and Present Value Factor

Year 1 = 5% (0.9524)

Year 2 = 6% (0.8900)

Value of Bond = Cash Flow1/(1+r)^1 + CashFlow2/(1+r)^n

or

(Cash Flow1 * Present Value factor Year1) + (Cash flow2 * Present Value factor Year2)

= (5*0.9524) + (105*0.8900)

=4.76 + 93.45

= $98.21 Million.

Alternative 2: if the face value of the new issue is $110 million.

As the bond will pay annually 1%, the bond will have following cash flows.

Year 1 = $1.1 (110*1%)

Year 2 = $110+ $1.1 (100*5%

Value of Bond = (1.1*0.9524) + (111.1*0.8900)

=1.048 + 98.879

=$99.93 million.

So the final answe of this case study is option B (My company will be able to raise $99.93 million and will not finance the project.)

Authors Bio: Cost & Management Accountant and currently working as Investment Analyst & Portfolio Manager.

jeff jeffy answered 2 years ago
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