Question

Suppose International Digital Technologies decides to raise a total of $200 million, with $100 million as long-term debt and $100 million as common equity. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT?

a. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.

b. The higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures.

c. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of debentures.

d. The higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be and, consequently, the higher the firm's total dollar interest charges will be.

e. In this situation, we cannot tell for sure how, or whether, the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two.

Answer 1

Option E
In this situation, we cannot tell for sure how, or whether, the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two

Higher percentage of mortgage bonds means less collateral each bond has leading to higher risk and required return. Also, this would mean less free assets for debentures leading to higher risk and required return. But mortgage bonds are less risky comapred to debentures, mortgage bond rates are less than rates on debentures. This leads to :greater percentage of mortgage bonds mean higherrate on both bonds, but average cost could be not said for certain-higher, lower or same.