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Chapter 7 Financing S& S Airs Expansion Plans with a Bond Issue

Financing S& S Airs Expansion Plans with a Bond Issue Mark Sexton and Todd Story,
the owners of S& S Air, have decided to expand their operations. They instructed their
newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $35
million in new 10- year bonds to finance construction. Chris has entered into discussions
with Renata Harper, an underwriter from the firm of Raines and Warren, about which
bond features S& S Air should consider and what coupon rate the issue will likely have.
Although Chris is aware of the bond features, he is uncertain about the costs and benefits
of some features, so he isnt sure how each feature would affect the coupon rate of the
bond issue. You are Renatas assistant, and she has asked you to prepare a memo to Chris
describing the effect of each of the following bond features on the coupon rate of the
bond. She would also like you to list any advantages or disadvantages of each feature:
Questions:
a
b
c
d
e
f
g
h
i
j

The security of the bond that is, whether the bond has collateral. (10 points)
The seniority of the bond. (10 points)
The presence of a sinking fund. (10 points)
A call provision with specified call dates and call prices. (10 points)
A deferred call accompanying the call provision. (10 points)
A make-whole call provision. (10 points)
Any positive covenants. Also, discuss several possible positive covenants S& S Air
might consider. (10 points)
Any negative covenants. Also, discuss several possible negative covenants S& S Air
might consider. (10 points)
A conversion feature (note that S& S Air is not a publicly traded company). (10
points)
A floating- rate coupon. (10 points)

Solutions:
a

A bond with collateral will have a lower coupon rate. This is because the
bondholders do not want to take risk since there are specific assets tied on the
bonds. Collateral provides an asset that bondholders can claim, which lower the
risk of default or no payment. Disadvantage of collateral is that the company
generally cannot sell the asset used as collateral and they should keep the asset
in good working order.

Seniority indicates preference in position within the investors. Debts may be


senior or junior to show their seniority. The more senior the bond is the lower
the coupon rate. Senior bonds get full payment in bankruptcy proceedings

before sub ordinated bonds receive any payment. A problem can arise that
contract may restrict the company from issuing any future senior bonds to the
current bonds.
c

A sinking fund will reduce the coupon rate because it is a partial guarantee to
bondholder in case of economic failure. A sinking fund is managed a bond
trustee for repaying bonds early. Disadvantage is that the firm must generate the
cash flow to make payments to the sinking funds.

A provision with specific date and prices would increase the coupon rate but it
would protest from paying a high rate for a long period in the event rates drop.
Company can refinance at a lower rate if interest rates fall significantly, enough
to offset the call provision cost.

A deferred call would reduce the coupon rate relative to a call provision without
a deferred call and the bond will still have a high rate. The deferred call means
that the company cannot call the bond for a specific period. The disadvantage of
a deferred call is that the company cannot call the bond during the call
protection period.

A make whole call provision should lower the coupon rate in comparison to a
call provision. The make whole call repays the bondholder the present value of
the future cash flows. Bondholders receive the market value of the bond, so they
can reinvest in another bond with similar characteristics. This whole call
provision should not affect the coupon rate.

A positive covenant would reduce the coupon rate. The presence of positive
covenants protects bondholders by forcing the company to undertake actions
that benefit bondholders. Example of positive covenants would be: the company
must maintain audited financial statements, the company must maintain a
minimum specified level of working capital or a minimum specified current
ratio, the company must maintain any collateral in good working order. The
negative side of positive covenants is that the company is restricted in its
actions. The positive convents may force the company into actions in the future
that it would rather not undertake.

A negative covenant would reduce the coupon rate. The presence of negative
covenants protects bondholders from actions by the company that would harm
the bondholders. Example of negative convents would be: the company cannot
increase dividends, or at least increase dividends beyond a specified level, the
company cannot issue new bonds senior to the current bond issue, the company
cannot sell any collateral. The downside of negative convents is the restrictions
of the companys action.

A conversion feature is the ability to change from one investment to another.


Even though the company is not public, a conversion feature would likely lower
the coupon rate. The conversion feature would permit bondholders to benefit if
the company does well and go public. The downside is that the company may be
selling equity at a discounted price.

Debt instrument with a variable interest rate. It is also known as a floater or


FRN. The downside of a floating rate coupon is that if interest rate rises, the
company should pay a higher interest rate. However, if the interest rate falls, the
company pays a lower rate.

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