In: Accounting
On July 1, 2015, ABC Co. issued 10-year, $4,574 million maturity value, 3% coupon bonds when the market rate was 2% for a cash price of $4,994 million. Interest was payable semi-annually on Dec. 31 and June 30. ABC also issued $3,527 million face value, 20-year, zero coupon bonds on July 1, 2017 that mature June 30, 2037 for a cash price of $2,619 million. The effective market interest rate at issuance was 1.5%. ABC repurchased $1,143 million face value coupon bonds on June 30, 2020 for $1,220 million cash (after interest was paid) and $582 million in face value of the zero- coupon bonds on June 30, 2021 for a purchase price of $432 million cash. 7. Why might company managers choose to issue zero-coupon bonds instead of interest-bearing bonds or coupon bonds instead of zero- coupon bonds? Give pros and cons of each. Why might they decide to repurchase some of the bonds before the maturity date? Be sure to consider whether management may choose to repurchase when interest rates are increasing or decreasing (both) and explain why.
1. The advantages of zero coupon bonds are ;
a. No annual interest payment during the life of the bond unlike interest bearing bonds
b. Predictable and fixed repayment amount.
c. Good for companies having cash crunch now but can have good cash flow in future to repay the bond unlike interest paying bonds which require fixed cash flow to service the interest pay out every year.
d. It is a long duration bond that gives access to fund with sufficient brathing time to repay.
Disadvantages of Zero coupon Bond ;
1. The duration is longer , so any adverse change in interest and inflation may result in the bond being costlier that couponed bonds.
2. It requires solid cash flow during repaymnet year to pay off the amount.
3. Zero coupon bonds are deep discount bonds , so the amount realised while selling is comparatively lesser.
Advantages of Interest bearing Bonds;
a. Cheaper source of fund that equity.
b. Interest payment is tax deductible.
c. There is option to reprchase when the market interest rate fall below the coupon rate.
d. Process of raising debt is easier than other capital raising options.
Disadvantages of Interest bearing bonds ;
1. The interest pay out as per bond covenant is a fixed charge that needs to be paid every period.
2. Adverse cash flow situation may make the interest paymnet difficult.
3. Adverse market interest rate or inflation rate movement may make the coupon rate higher that existing market rate.
4. Excess issue of bond may make the gearing risky and the compaany may face bankruptcy risk in case of excessive gearing.
Repurchase of Bonds :
a. When Market interest rate is decreasing ;
When the market interest rate decreases below the coupon rate of the bond, a company effectively incurs a higher cost on debt than market rate. At this situation a company may repurchase the bond and re-issue the bonds at a lower coupon rate ( in line with the market rate) . This way the company can reduce the cost of capital.
b. When the Market interest rate in increasing;
When the market interest rate increases above the coupon rate , the market value of the bond decreases below the par value of the bond. If a company repurchases bonds before maturity , it can use this situation to buy back the bonds at lower than face value. Such situations are used by companies which want to reduce the excess gearing and want to correct their capital structure by reducing the debt at lower than face value.