QUESTIONS AT BOTTOM

Alternative #2 Callable Bonds Maurine Stewart feels that the conventional bond alternative is acceptable. But is it optimal? She asks the investment banker to investigate the cost of issuing a bond with a five-year call feature. While a call feature is a benefit for the issuer because the issuer could call the bond if interest rates went lower, it is an additional risk to the bond investor because the investor would receive cash that needed to be reinvested just when interest rates were low. So the investment banker explains that if a call feature were added, the yield to maturity will have to be % higher in order to entice investors to buy it. For example, if a conventional bond could be sold with an 8.00% coupon at 100% of face value then a callable bond would have to have a coupon rate of 8.25% to be sold at 100% of face value. Another custom dictates that a call premium equal to the amount of one coupon payment must be added to the face value for the early redemption. For example, if the coupon rate were 9.00%, the call premium would be 4.50% which means that the bonds could be called from the investors by W. F Prince at 104.50% of face value. Finally another convention gives the investor protection against a call for five years. That is, the earliest that a bond could be called would be five years from its issue date. To sum: all of the features would be the same as in Question 3 except that (1) the yield to maturity and the coupon rate would be 0.15% higher, and (2) the call premium would one half the coupon rate.

All of the relevant information is gathered in the table below. Data Relevant to the Conventional Bond Alternative a. Maturity Twelve years b. Face Value $50,000,000 c. Price to Investors 100% of face value d. Yield to Maturity Equal to the non-callable bonds + 0.15% e. Coupon rate Same as the yield to maturity for investors f. Flotation Fee 4.00% g. Call Protection Five years h. Call Redemption Amount 100% of face value plus one extra coupon

Q5. What would be the coupon rate of the callable bond?

Q6. What would the call premium be?

Q7. What would the yield to maturity (YTM) to the investors be for the callable bond?

Q8 What would the yield to call (YTC) to the investors be for the callable bond? (This calculation assumes that they hold it for five years and then the company redeems it.)

Q9. What would the interest rate cost of this alternative financing, taking account the flotation cost, for this company be on the basis of its maturity (not call date)?