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• To fund some of its expansion plans, Orlando Rubber & Tire (ORT) recently issued 30-year bonds with low coupon rates. Investors were willing to purchase the bonds despite the low coupon rates because ORTs debt has consistently been rated AAA during the past decade, which means that bond rating agencies consider the companys default risk to be extremely low.
• Now ORT is considering raising additional funds by issuing new debt. The company plans to use the new funds to finance additional expansion. Unlike its previous expansion efforts, however, ORT now plans to grow the firm by purchasing young firms that just went public that are not in the tire and rubber industry.
• Sally, who works closely with ORTs investment banker, has been assigned the task of determining how to best raise the desired funds. After speaking with the investment banker, some friends who work at other companies, and peers in ORTs international subsidiaries, Sally is seriously considering recommending to management that ORT issue a new security that has the characteristics of both debt and equity. The security, which was recently introduced in the U.S. financial markets, is classified as debt because fixed interest payments that are tax deductible are paid every year. Unlike conventional bonds, however, these hybrid bonds, which are called boondocks, have maturities of 50 to 60 years. In addition, the firm is not considered to be in default if it misses interest payments when the firms credit rating drops below B+. Most experts consider boondocks to be quite complex financial instruments.
• Through her research, Sally discovered that boondocks have been used for quite some time outside of the Unite States. Compared with conventional debt, companies that have used boondocks have increased their earnings per share (EPS) significantly. A major reason EPS increases is because the cost of a boondock generally is much lower than equity, but the instrument is comparable to equity financing with respect to maturity and default risk. For example, Sally discovered that ORT could issue boondocks with an after-tax cost equal to 5%, which is only slightly higher than the after-tax cost of issuing conventional debt and is approximately one-third the cost of issuing new equity. Although boondocks are considered risky, the actual degree of risk is unknown. The friends and coworkers with whom Sally consulted seem to think there is a slight chance that investorsboth stockholders and bondholderswould earn returns significantly lower than would be earned with conventional debt when the company performs extremely poorly. The opposite should occur when the company performs very well.
• The major drawback to issuing boondocks is that they will significantly increase the financial leverage of ORT, and thus the value of the recently issued bonds will decrease substantially.On the other hand, Sally thinks that issuing boondocks can be a win-win proposition for ORT and its common stockholders. If the companys expansion plans are unsuccessful, the market values of both its debt and its equity would decrease to the point that it would be attractive for the firm to repurchase these financing instruments in the capital markets. If this is true, then issuing boondocks would benefit stockholders at the expense of bondholders. ORTs executives are major stockholders because their bonuses and incentives are paid in the companys stock.
• Write an essay that addresses the following questions about this situation:
• Is there an ethical problem? If so, what is it?
• What are corporate bond credit ratings and how are they determined?
• Is it appropriate for ORT to use boondocks to raise funds that are needed for expansion? Why or why not?
• What obligation do corporations have to their stock holders?
• What obligations do corporations have to their bond holders?
• What would you do if you were Sally?