Mark Sexton and Todd Story, the owners of a manufacturing company have decided to expand their operations. They instructed you as their newly hired financial analyst to enlist an underwriter to help sell $35 million in new 10-year bonds to finance construction. You have entered into discussion with Kim McKenzie, an underwriter from the firm of Raines and Warren about which bond features your company should consider and what coupon rate the issue will likely have. Although your Bosses are aware of the bond features, they are not sure about the costs and benefits of some features especially how they will affect the coupon rate of the bond issues. This is more so that your firm is not a publicly traded company. You have been asked to prepare a memo on the effect of each of the following bond features on the coupon rate of the bond. It is expected that you will emphasis on their perceived benefits. The bond issuer/the borrower/the bosses: Mark Sexton and Todd Story Bond value: $35 million
Bond maturity: 10 years
Financing purpose: construction
Hired underwriter: Kim McKenzie (Raines and Warren)
.Case Studied Memos:
1. The security of the bond- that is, whether the bond has a collateral. Secured bond is with collateral, whereby the issuer pledged specific assets in case of bankruptcy or unable to pay debt. A bond with collateral will have a lower coupon rate (interest/return) and lower the security’s risk but with higher credit ratings, which less likely it is to default. But the issuer need to ensure that the collateral is in good working order and cannot be sold until the bond is matured. Considering bond with collateral is secured investment to investors, during default, the investors may receive all or part of the collateral in the value of debt unpaid. Collateralized bond is also marketable to the secondary market especially if it is a non-publicly traded or listed company recognized among investors. In term of outlining the specific security of collateral attached to a bond, it’s best to put clear guideline of what sort of asset eligible to be put as collateral and define certain rule of how the asset’s value can be sum up to secure the bond maturity period.
2. The seniority of the bond
In case of liquidation or bankruptcy, senior bond has higher priority to be paid first compared to another bond that is considered junior or the subordinated bonds. Senior bond gets full payment in bankruptcy which its covenant may restrict the borrower from issuing any future bonds senior to the current bonds. A junior bond’s security ranks lower than other bond securities in regard to the owner's claims on assets and income if the issuer becomes insolvent. Bondholders of secured debt (with collateral) must be paid before the holders of unsecured debt. Bondholders of unsecured debt must be paid before preferred shareholders, and finally, preferred shareholders must be satisfied before common shareholders. In general, a junior security entails greater risk but offers higher potential yields than securities with greater seniority. To be more appealing to investors, the bondholders should propose senior bond in able to offer lower coupon.
3. The presence of a sinking fund
Bond sinking fund is a restricted asset where the issuer is required to set aside money for redeeming back or buying back some of its bond payable by deposited money with an independent trustee. Sinking fund is a partial guarantee to bondholders that will reduce the coupon rate. By having sinking fund, it allows the issuer to repay specific bond’s value at a certain period or retire a portion of the bond every year until it’s matured. It’s a great program but the issuer must be able to generate cash flows to make the interim payments into a sinking fund or else, face default. By having the presence of a sinking fund as collateral support of a bond, it promotes financial security...