W. F. Prince is a wholesaler of industrial lighting fixtures with sales of around $190,000,000 per year. The company currently outsources almost all of its manufacturing to Chinese firms and its assets consist mainly of distribution centers, a research and development center, a number of valuable patents, copyrights, and a well regarded brand name among large construction companies. The CEO, who is expected to retire in two years, holds stock options that might be worth as much as $4,000,000 but are not exercisable until retirement. So he is contemplating having the company raise around $50,000,000 by issuing ten-year bonds so it can repurchase its own stock, increase earnings per share, and drive up the stock price. This case is about how the CFO, Maurine Stewart, determines the best way to finance this maneuver.

1. The CFO, Maurine Stewart, has approached an investment banker who wants her to consider a funding bid by a pension fund that is interested in buying the entire issue in a private placement. By buying the bond privately the pension plan can impose more stringent covenants in the indenture and can have access to non-public information about the companys performance. The company benefits because it will not have to register the bonds with the SEC and produce a proxy statement. The company would, however, make a public announcement of the sale because the purchase by this particular fund would serve as a sort of endorsement of the companys credit worthiness and eventually the increased debt load would be reported on the firms quarterly statements anyway. Because of its particular cash flow needs, the pension fund would like to purchase a bond that matures in eight years with a face value of $60,000,000. Interest rates are low at the time of this story so the pension fund is willing to accept a coupon rate of only 5.50%. But the fund requires a yield to maturity of 7.00% so it will actually lend less than the $60,000,000 face value. What is the amount of the funding W. F. Prince can raise if it accepts these terms from the pension fund? This question calls for a dollar figure.

2. The investment banker points out that his firm is entitled to a brokerage fee (it is like a flotation fee) of 2% that would be paid by W. F Prince. Brokerage and flotation fees are "one-time" fees that are paid only at the time a deal is consummated. Brokerage fees like this are always paid on the amount of money actually raised not on the money ultimately owed. What is the net amount that W. F. Prince can raise after the 2% brokerage fee is paid? That is, how much does FWPrince receive if it receives only 98% of the money raised? This question calls for a dollar figure.

3. What would be the cost of funding (that is the long term interest rate on the funds) after W. F Prince pays the 2% brokerage fee? This question calls for an interest rate that is calculated over the life of the bonds. See Slides #34 through #37.

4. Maurine Stewart points out that another firm, Gregory Scott Inc. which deals with industrial flooring and carpeting and has cash flow and risk characteristics similar

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to W. F. Prince, has a publicly traded bond outstanding. That bond is a ten year bond, with a coupon rate of 8.00%, and is trading at 109.365% of face value. Moreover, as a publicly traded bond it has fewer covenants and the company does not have to reveal private information to the bond holders. What is the yield to maturity of the 8.00%, ten year Gregory Scott bond? This question calls for an interest rate calculated over the life of the bonds.

5. The investment banker points out that if W. F. Prince issues a publicly traded bond then the investment banker must purchase the entire issue and market it piecemeal to a number of buyers in a full fledged underwriting process. While under the private placement alternative the investment banker was serving as a broker (a go between not exposed to risk), the public issue alternative entails interest rate risk and a greater sales effort. When bonds are sold to the public the underwriter must buy the entire amount from the issuer and then sell it piece by piece to the ultimate investors as quickly as possible so it does not end up holding them if interest rates rise or another similar issue comes forth to cause congestion in the market. For this risk, and for the marketing services it must render, the investment bank would charge a flotation fee of 4% of the initial amount raised. The flotation fee is a one-time fee paid at the beginning of the life of the bond. This charge would be born by W. F. Prince. To summarize, if the CFO decided to go with the ten year publicly traded bond it would have the following characteristics:

a. Maturity: Ten years

b. Face Value: $50,000,000

c. Price: 100% of Face Value

d. Yield to Maturity: The same as the industrial flooring

company bonds

e. Coupon rate: The same as the yield to maturity

f. Proceeds to W. F. Prince: 96% of face value.

If the CFO decides to go with this option what would the interest rate funding cost be to W. F. Prince? This question calls for an interest rate that is calculated over the life of the bonds. For this question you can work with a face value of 100% or $100 and get the correct answer. See Slides #34 through #37 of the Bond PowerPoint lecture for a hint.

6. The CFO is leaning toward the public issue alternative. But in spite of the low interest rate environment 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 were even lower, it is an additional risk to the bond purchaser because if the bond were called the purchaser would receive cash that would require reinvestment 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 0.30% (a little less than 1/3 of a percentage point) higher in order to entice investors to buy it. As is the normal custom, the coupon rate would be such that the market value of the bond would be

100% of face value ($50,000,000). Another custom dictates that the call premium be equal to par plus the amount of one six-month coupon. In other words, 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 in five years at 104.50% of face value. To sum: all of the features would be the same as in the previous question except that (1) the yield to maturity and the coupon rate would be 0.30% higher, and (2) the call premium would one half the coupon rate. These data are summarized below:

Callable Bond Option

a. Maturity: Ten years

b. Face Value: $50,000,000 (work with 100%)

c. Price: 100% of Face Value

d. Yield to Maturity: Equal to the industrial flooring

company bonds plus 0.30%

e. Coupon rate: The same as the yield to maturity

f. Proceeds to W. F. Prince: 96% of face value

g. Call Premium the coupon Rate

h. Amount Paid if Called 100% + Call Premium

What would the required yield to maturity for investors? This question just calls for adding 0.30% onto the yield to maturity and onto the coupon rate that you calculated in the previous question.

7. What would be the call premium? This question can be expressed in many ways but it is easier to think of the face value of the bonds as 100 or 100% rather than $50,000,000. But it merely calls for the add-on to the face value (100% or $50,000,000) that is of the annual coupon rate. See Slides #43 through #48.

8. If the bonds do indeed trade at 100% of face value, what would be the yield to call for the investors? Be sure to use the data from Question 6 and not Question 5. See Slides #43 through #48.

9. If the broker charged a 4% flotation fee based on the initial issue amount, what would be cost of funding (yield to maturity not yield to call) to W. F. Prince? This question calls for an interest rate that is calculated over the life of the bonds.

10. In your opinion, which alternative should Maurine Stewart, the CFO choose?

a. Private placement of the 5.50% 8 year bond under the terms of Questions 1, 2, and 3.

b. Public issue of a non-callable ten year bond under the terms of Questions 5.