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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

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.

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