eBook

Problem 13-12

Mike Smith, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company corporate bond. He has collected the balance sheet and income statement information for Montrose as shown in Table 1 below.

Table 1 Montrose Cable Company Year Ended March 31, 2017 (USD Thousands)
Balance Sheet
Current assets	$4,700
Fixed assets	43,215
Total assets	$47,915
Current liabilities	4,440
Long-term debt	10,000
Total liabilities	$14,440
Shareholders' equity	33,475
Total liabilities and shareholders' equity	$47,915
Income Statement
Revenue	$18,550
Operating and administrative expenses	14,110
Operating income	$4,440
Depreciation and amortization	1,700
Interest expense	945
Income before income taxes	$1,795
Taxes	632
Net income	$1,163

He has also calculated the three ratios shown in Table 2 below, which indicate that the bond is currently rated "A" according to the firm's internal bond-rating criteria.

Table 2 Selected Ratios and Credit Yield Premium Data for Montrose
EBITDA/interest expense	4.70
Long-term debt/equity	0.30
Current assets/current liabilities	1.06
Credit yield premium over U.S. Treasuries	59	basis points

Smith has decided to consider some off-balance-sheet items in his credit analysis, as shown in Table 3.

Table 3 Montrose Off-Balance-Sheet Items

• Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $970,000.
• Montrose has sold $510,000 of accounts receivable with recourse at a yield of 8 percent.
• Montrose is a lessee in a new noncancelable operating leasing agreement to finance transmission equipment. The discounted present value of the lease payments is $6,130,000 using an interest rate of 10 percent. The annual payment will be $1,000,000.

Specifically, Smith wishes to evaluate the impact of each of the off-balance-sheet items on each of the ratios found in Table 2. Assume that the "loan proceeds" from the financed receivables would be invested at interest rate of 8 percent.

1. Calculate the combined effect of the three off-balance-sheet items in Table 3 on each of the following three financial ratios shown in Table 2. Do not round intermediate calculations. Round your answers to four decimal places.

   1. EBITDA/interest expense:
   2. Long-term debt/equity:
   3. Current assets/current liabilities:

2. Evaluate whether or not the credit yield premium incorporates the effect of the off-balance-sheet items, state and justify whether or not the current credit yield premium compensates Smith for the credit risk of the bond, based on the internal bond-rating criteria found in the firm's internal bond-rating criteria. Round your answers to the nearest whole number.

   		Credit Yield Premium
   		over U.S. Treasuries
   	Bond Rating	(in basis points)
   Interest Coverage	-Select-AAABBBBBItem 4
   Leverage	-Select-AAABBBBBItem 6
   Current Ratio	-Select-AAABBBBBItem 8

   The current rating of the Montrose bond as an "A" -Select-does not incorporateincorporateItem 10 the effect of the off-balance-sheet items, and the current credit yield premium of 59 basis points -Select-isis notItem 11 sufficient to compensate Smith for the credit risk of the bond.