Question
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
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 | $4,730 | |
Fixed assets | 43,250 | |
Total assets | $47,980 | |
Current liabilities | 4,460 | |
Long-term debt | 10,000 | |
Total liabilities | $14,460 | |
Shareholders' equity | 33,520 | |
Total liabilities and shareholders' equity | $47,980 | |
Income Statement | ||
Revenue | $18,550 | |
Operating and administrative expenses | 14,100 | |
Operating income | $4,450 | |
Depreciation and amortization | 1,630 | |
Interest expense | 939 | |
Income before income taxes | $1,881 | |
Taxes | 778 | |
Net income | $1,103 |
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 | 4.74 | |
Long-term debt/equity | 0.30 | |
Current assets/current liabilities | 1.06 | |
Credit yield premium over U.S. Treasuries | 60 | 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 $995,000.
Montrose has sold $500,000 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 $6,138,000 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.
a) 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.
EBITDA/interest expense: _______
Long-term debt/equity: _______
Current assets/current liabilities: _______
b) 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 | (AA / A / BBB / BB) | __________________ | |
Leverage |
| __________________ | |
Current Ratio |
| __________________ |
The current rating of the Montrose bond as an "A" (does not incorporate / incorporate) the effect of the off-balance-sheet items, and the current credit yield premium of 60 basis points (is / is not) sufficient to compensate Smith for the credit risk of the bond.
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