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Question: Bond Selection FINANCING EAST COAST YACHT’S EXPANSION PLANS WITH A BOND ISSUE After Dean’s EFN analysis for East Coast Yachts (see the Closing Case in Chapter 3), Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $40 million in new 20-year bonds to finance new construction. Dan has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. 6. Are investors really made whole with a make-whole call provision? 7. After considering all the relevant factors, would you recommend a zero coupon issue or a regular coupon issue? Why? Would you recommend an ordinary call feature or a make-whole call feature? Why?
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Question: Bond Selection FINANCING EAST COAST YACHT’S EXPANSION PLANS WITH A BOND ISSUE After Dean’s EFN analysis for East Coast Yachts (see the Closing Case in Chapter 3), Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $40 million in new 20-year bonds to finance new construction. Dan has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. 6. Are investors really made whole with a make-whole call provision? 7. After considering all the relevant factors, would you recommend a zero coupon issue or a regular coupon issue? Why? Would you recommend an ordinary call feature or a make-whole call feature? Why?

by Chief OxMay 16, 2020

Bond Selection

            The made-whole provision is put in place to protect bondholders so that they do not suffer a loss in the event of a call of a bond (Ross, Westerfield, Jordan, 2008 However, investors are not truly made whole using the make whole call provision. Instead, rather, they are made as close to whole as possible. The reason bondholders are not truly made whole using the make whole call provision is because the price of the bond changes with the treasury price. The discount rate associated with the bond is an average over the lifetime to maturity of the bond. This means that there is likely to be some sort of fluctuation in the discount rate from day to day. Therefore, when a bond is called, it is called at the current treasury rate of that day. This fluctuation causes bondholders to be made as close to whole as possible but not completely whole.

            Before deciding to use a zero coupon issue or a regular coupon issue, it is important to understand the differences between the two. A zero coupon issue does not pay any interest during the life of the bond. Instead, rather, it pays the interest at the maturity of the bond. On the other hand, a regular coupon issue would pay out periodic interest over the life of the bond. Due to the new construction project that Larissa wants to undertake it would be advisable to go with a zero coupon issue bond which maintains cash flow at the beginning of the lifetime of the bond. Additionally, I would recommend using a make-whole call feature for the East Coast Yachts bond issue. I recommend this feature due to the fact that the organization can reduce their overall interest cost associated with the bond issue. The organization’s interest cost can be reduced as a lower interest rate can be offered to bondholders due to the protection that is provided to them through the make-whole provision.  

References

Ross, S.A., Westerfield, R., Jordan, B.D. (2008). Fundamentals of corporate finance. New York, NY: The McGraw-Hill Companies, Inc.

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