Question

Shelly’s Auto Repair, a private company, is preparing to issue a bond to open a new branch in an up-and-coming city. The bookkeeper, Carson Booker, plans to amortize the bond using the effective-interest method. For calculation purposes, assume the following information:
The bond is expected to be a 5-year, $100,000 face value, 6% bond with an effective annual yield of 5%. Interest will be payable semiannually. If all goes well, the bond will be issued on March 1, 2021, and the first interest payment date will be September 1, 2021. The bonds are expected to be callable at 102 at any time on or after March 1, 2023.

Requirements

You have been hired as an expert on bonds to write a memo to Carson explaining how the call feature could affect their business. Be sure to include the following:

a) Educate the company on how bond redemptions work. What are the pros and cons of calling the bond before maturity? What are some things to consider?

b) Include an amortization schedule using the effective interest method as an exhibit to follow your memo (you do not need to consider prorations).

Answer 1

a) A bond is a mode of raising capital by the company. It is a debt which is repayable as per terms of issue. A bond with call features gives the flexibility to management to recall the bond and repay the same to the bondholders. The redeemable price of the bond is known as call price which is fixed as a percentage of issue price . For example a bond of $1,000 callable at 103 means the redemption price is $1,030 per bond. When bonds are redeemed the carrying value of bond is compared with redemption value to find the gain or loss on redemption of bond. If the carrying value is higher than bond redemption value there is gain on redemption of bond. If the carrying value of bond is lower and bond redemption value is higher there is loss on redemption of bond.

The pros of calling bonds before maturity are

· It helps in managing the financial position of the company

· It helps in bond redemption when interest rate is favorable to the firm

· It gives flexibility to the firm to manage capital requirements

· It helps in managing ratios like Debt equity and Debt to total assets

The cons of calling bonds before maturity are

· Redemption of bonds involves lot of administrative work and effort of the management

· It impacts the image of the firm in the bond market

· It leads to duplication of work if bonds are again issued in market to raise capital

Some other things to consider by management are the sentiment of market and investors before redemption of bond. A firm should ensure its image is not impacted in public due to bond redemption before maturity.