Question

If the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering issuing stock or bonds to raise funds in the next year.

a. Assume that Carson has two choices to satisfy the increased demand for its products. It could increase production by 10 percent with its existing facilities by obtaining short-term financing to cover the extra production expense and then using a portion of the revenue received to finance this level of production in the future. Alternatively, it could issue bonds and use the proceeds to buy a larger facility that would allow for 50 percent more capacity. Which alternative should Carson select?

b. Carson currently has a large amount of debt, and its assets have already been pledged to back up its existing debt. It does not have additional collateral. At this time, the credit risk premium it would pay is similar in the short-term and long-term debt markets. Does this imply that the cost of financing is the same in both markets?

c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson decide not to include a call provision on the bonds?

d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a private placement of bonds? What type of investor might be interested in participating in a private placement? Do you think Carson could offer the same yield on a private placement as it could on a public placement? Explain.

Answer 1

a. Carson should not purchsae a larger facility until he does not feel condifent that he is able to ultize the space fully. Also he should considered the excesss capcicity by using it for an existing facilitity for the short period of time and also at the same time it also monitors the growth of the economy. By this way, there is a need of only short term financing and can be ignored the long term debt. But in the case when the demand is not rise as expected so it would retired the short term debt when the maturity date is come. On the other hand, if he feel confident regarding the rise in demand also he would be brave for teh long run so the issuance of the long term bond could be done for the expansion purpose.

b. No as it represents the upward solping yield curve in this case he should obtained short term financing at lesser rate of interest rather go for long term financing

c. The call provision gain could be in term when the bonds are retired before its maturity date. Now if he wants to decrease the debt or the rate of interet fall also wanted to again refinances at lesser date so in this case he should have to pay higher yield so that the bondholders could be compensated also it should involves the call provision in the bonds

d. He should considered a private placement due to this he is able to decrease the transactions cost. Also the insurance company are willing to participate as an investor in the market. But the investor has to accept the secondary market lacking for the bond purpose. He has to pay the higher yield on the private placement so that it could represent the liquidity lacking i.e it does not involved the secondary market for the bond motive