Problem David Wright, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company corporate bond. He has collected the following balance sheet and income statement information for Montrose as shown in Exhibit 10.10. He has also calculated the three ratios shown in Exhibit 10.11, which indicate that the bond is currently rated A" according to the firm's internal bond-rating criteria shown in Exhibit 10.13. Wright has decided to consider some off-balance-sheet items in his credit analysis, as shown in Exhibit 10.12. Specifically, Wright wishes to evaluate the impact of each of the off-balance-sheet items on each of the ratios found in Exhibit 10.11 a. Calculate the combined effect of the three off-balance-sheet items in Exhibit 10.12 on each of the following three financial ratios shown in Exhibit 10.11 i. EBITDA/interest expense ii. Long-term debtequity ii, Current assets/current liabilities The bond is currently trading at a credit premium of 55 basis points. Using the internal bond- rating criteria in Exhibit 10.13, Wright wants to evaluate whether or not the credit yield premium incorporates the effect of the off-balance-sheet items b. State and justify whether or not the current credit yield premium compensates Wright for the credit risk of the bond based on the internal bond-rating criteria found in Exhibit 10.13. Exhibit 10.10 Montrose Cable Company Year Ended March 31, 2011 USS Thousands) Balance Sheet 4,735 Curront assets Fxed assets 43225 $47 960 Total assets 4,500 Current liabilities Long-term debt Total liabilidies 3360 $47.960 Total liabilities and shareholder's equity $18,500 Operating income Interest expense Income before income taxes 1,833 Net income Exhibit 10.1 1 Selected Ratios nd Credit Yield Premlum Data for Montros. Long-term debtequity Current assets/current liabalities Credit yield premium over U.S. Treasuries 4.72 0.30 1.05 55 basis points Exhiblt 10.12 Montrose Off-Balance-Sheet Items Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affi ate This obligation has a present value of $996,000 Montrose has sold $500,000 of accounts receivable with recourse at a yield of 8 percent Montroso is losseo in a now noncancelatde operating loasing agreement to finance $6,144,000 using an intorest rate of 10 percent. The annual payment will be $1,000,000. Exhibit 10.13 Blue River Investments: Internal Bond-Rating Criteria and Credit Yield Premlum Dats Gredit Yield Prous over US. Treasaries n basis poists 30 bps 50 bps 100 bps 125 bps Intent Coverage Car R tio ECument Bond Ratin liabiities 5.00 to 600 4.00 to 500 3.00 to 400 2.00 to 300 0.25 to 0.30 0.30 to 0.40 0.40 to 0.50 0.50 to 0.60 15 to 125 1.00 to 1.15 0.90 to 100 0.75 to 090
