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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	$4,735
Fixed assets	43,300
Total assets	$48,035
Current liabilities	4,580
Long-term debt	10,000
Total liabilities	$14,580
Shareholders' equity	33,455
Total liabilities and shareholders' equity	$48,035
Income Statement
Revenue	$18,590
Operating and administrative expenses	14,140
Operating income	$4,450
Depreciation and amortization	1,645
Interest expense	931
Income before income taxes	$1,874
Taxes	684
Net income	$1,190

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	4.78
Long-term debt/equity	0.30
Current assets/current liabilities	1.03
Credit yield premium over U.S. Treasuries	57	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 $980,000.
• Montrose has sold $500,000 of accounts receivable with recourse at a yield of 10 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 $6,144,000 using an interest rate of 12 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 10 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-AA,A,BBB,BB
   Leverage	-Select-AA,A,BBB,BB
   Current Ratio	-Select-AA,A,BBB,BB

   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 57 basis points -Select-isis notItem 11 sufficient to compensate Smith for the credit risk of the bond.