W.F. Prince Bond Financing Case 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 wellregarded 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. The CFO, Maurine Stewart, has the responsibility for raising funds for the company. Because this borrowing is replacing common equity, she feels that a long term, fixed rate lending instrument is more appropriate than a short term, floating rate loan from a bank. Personally she would like to issue a 30-year bond. But interest rates tend to be higher for longer times to maturity so she and the CEO have settled on a maturity of around ten years, plus or minus a year or two. W. F. Prince has had a long commercial banking relationship with Citibank so it is an easy matter for Stewart to call her account manager to get some initial advice. Commercial banking is more about cash, short term liquid investments, payments services and short term loans than long term financing but Stewart thinks that her account manager at Citibank can recommend an investment bank to underwrite the longer term borrowing that she was seeking. To her surprise, Brad Weatherton, her account manager, is eager to extol the virtues of his own institution in raising long term financing. In fact, Weathertons endorsement of his own institutions investment banking services is enthusiastic enough to give Stewart pause. She wonders how much the bank will earn if she uses it as its investment banker. There are a number of alternative financing instruments. She can sell a private placement to a pension plan, issue a ten year straight bond in the public market, or issue a callable bond in the public market. Each of these alternatives has a slightly different cash flow both in the terms of the initial amount raised but also the interest payments that are made over time. They also present different risk factors and carry different covenants. Each of these alternatives needs to be explored. Alternative 1: A Conventional Bond The most common plain vanilla way of doing this financing is with a conventional ten year bond that pays interest semiannually. Conventional bonds are issued at face value with a coupon rate equal to the bonds yield to maturity. In the case of W. F. Prince the bond would be issued for $50 million and be redeemed at the end of ten years for $50 million. The twice-annual coupon would be calculated as a percent of the final value and their annual sum would be called the coupon rate. Because the issue price and the 2 redemption amount would be the same, the percent coupon rate and the yield to maturity are the same. The Conventional Underwriting Process Publicly issued and traded bonds tend to have lower interest rate costs than other sources of financing but they are subject to a great deal of regulation including the need for registration with the SEC. One does not begin the issuing process unless they are committed to seeing it through to the end. Maurine Stewart is not ready to make such a commitment. She needs to learn more about the covenants that will be required by the investors, roughly how much it will cost to borrow money through this alternative and how this form of financing compares to other forms. Obviously one of the key issues is how high a coupon rate will be necessary to attract investors. The higher the coupon rate the better off the investors would be but the worse off W. F Prince will be. The yield to investors is the cost to W F. Prince. But determining the lowest market-worthy rate is not an exact science. Prices and yield to maturities are changing all of the time and the bonds of companies with different credit risk levels trade at different yields. The most common to approach to estimating the lowest possible yield is to pursue a three-stage process: 1. First a comparison bond or a list of comparison bonds are identified. A comparison bond must be a seasoned bond which means that its sale has been completed and the owners of the bonds are mostly long term investors. The comparison bond must have been issued by company similar to the new bond issuer. In particular the comparison bond must have the same credit rating and it is best if the comparison company is in the same business. No matter what the original maturity of the comparison bond was when it was issued it must now have a similar time left to maturity as the proposed new bond. That is, if W.F. Prince wants to issue a ten year bond then the comparison bond should have a time left to maturity of at least nine and no more than 12 years. 2. Once the comparison bond is identified then the second stage is to use it to establish the coupon interest rate of the new issue. The coupon rate will be equal to the comparison bonds yield to maturity after certain adjustments. a. A brand new issue will have a coupon rate that is slightly higher than that of a similar seasoned bond to accommodate the initial surge of supply that will hit the market place. b. The coupon rate will adjust slightly for any difference in the credit quality between the new issuer and the comparison company. c. If there is a difference in maturity then there might be a slight adjustment for that too usually the longer the time to maturity of the new bond the greater the increase in the coupon rate. d. If the new issue is to be a callable bond when the comparison bond is not then a substantial add on to the yield to maturity will be necessary to attract investors. 3. Another major adjustment is the fact that when a company issues a new bond, the firm underwriting it collects a flotation fee. A flotation fee is a percentage of face 3 value that the underwriter pockets. For example, if W.F. Price were to issue $50 million new bonds and if the flotation fee were 3%, then W.F. Prince would actually receive only $38,800,000. This drives up the per dollar percentage cost of finance for the issuer higher than the yield to maturity that the investors earn. Flotation costs are substantial but underwriters justify them because they prepare all of the documentation, use their contacts with investors to sell the bonds and ultimately use their own capital to buy the entire bond reducing the risk to the borrower. After they buy the entire bond they try to sell it quickly (within three days) in case market conditions deteriorate. A Comparison Bond for W.F. Prince To find the appropriate coupon rate/yield to maturity for W. F. Prince, Brad Weatherton selects another firm in the wholesale building supply business, Sternwood and Bresseta Inc..which deals with industrial flooring and carpeting. Sternwood and Bresseta Inc. has similar free cash flow and risk characteristics as W. F. Prince and has a publicly traded bond outstanding. That bond was issued a long time ago but now has ten years left to maturity. The bond must have been issued when interest rates were higher than they are today because it has a coupon rate of 8.00% and is trading at 109.365% of face value. The amount outstanding is not relevant. Bond valuation arithmetic gives one the luxury of pretending that the amount issued was $100, that the coupons are four dollars every six months, the face value is $100 and its market price is $109.365. This simplifies calculation but one must be mindful that actual amounts are working in millions of dollars not hundreds of dollars so the $0.005 is very important. Q1 What is the yield to maturity for investors of the comparison bond? Once we know the yield to maturity of the comparison bond we need to make adjustments. The comparison bond is a seasoned issue. It is reasonable to assume that W.F. Prince would have to provide a higher yield to maturity to attract enough investors to sell the entire $50 million. Weatherton figures that W.F. Prince would need to add 0.15 percent (not 15%) to the yield to maturity of the comparison bond to attract enough investors. Maurine Stewart points out, however, that industrial flooring is more cyclical than industrial lighting. Floors are a major capital expense and are installed when economic times are good but demand trails off in bad times. This is true for lighting but not to the same extent. Replacing lighting fixtures is less of an investment so demand for industrial lighting varies less across business cycles. In the end Weathertoin agrees that the appropriate add-on to the yield to maturity should be 0.10 % (not 10%). Q2. What would the coupon rate of W. F. Princes bond need to be to attract enough investors? W. F. Prince would not collect the entire proceeds. In fact Citibank wants to charge a flotation fee of 4%. That means that W. F. Prince would not receive the entire 50 million but only 96% of that amount. Of course they could increase the face value to $52,083,333 but at this point we are seeking the interest rate cost of borrowing money so 4 this detail can be attended to later. Here is a summary of what we know so far, a. Maturity Ten years b. Face Value $50,000,000 c. Price to Investors 100% of face value d. Yield to Maturity Same as the Industrial Flooring Company bonds + 0.10% e. Coupon rate Same as the yield to maturity for investors f. Flotation Fee 4.00% g. Proceeds to W. F. Prince 96% of face value Q3.What will the interest rate cost of the bonds be to W. F. Prince for the conventional bond alternative? 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.1 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 5 except that (1) the yield to maturity and the coupon rate would be 0.25% higher, and (2) the call premium would one half the coupon rate. All of the relevant information is gathered in the table below. 1 See the last two pages of this document for further explanation. 5 a. Maturity Ten 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 + 0.25% e. Coupon rate Same as the yield to maturity for investors f. Flotation Fee 4.00% g. Proceeds to W. F. Prince 96% of face value h. Call Protection Five years i. Call Redemption Amount 100% of face value plus one extra coupon Q4 What would be the coupon rate of the callable bond? Q5 What would the call premium be? Q6. What would the yield to maturity (YTM) to the investors be for the callable bond? Q7 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. Q8 What would the interest rate cost of this alternative financing be on the basis of its maturity (not call date)? Alternative #3 Private Placement Citibank is in contact with a major pension fund that was seeking to invest money privately instead of buying publicly traded bonds. Long term loans that are made by pension plans, life insurance companies and closed end mutual funds are called private placements. For investors they have several advantages. First, because they do not trade publicly they are not marked to market as publicly traded bonds are. Only if interest rates change drastically or if the borrower gets into financial trouble are the bonds re-evaluated. That means that most of the time the reported value of a portfolio of private placements does not fluctuate. Second, private placements can be tailored to the needs of the investor. This is particularly useful for pension plans who can easily meet immediate cash outflow needs but struggle to find investment opportunities that pay large cash flows far into the future when they need them to meet their pension obligations. Third, the private placement investor is privy to more information about the companys financial condition and strategic position than the general public. Companies are allowed to provide them with information that they withhold from the public Companies with strategies or resources that they would prefer to keep secret often choose this alternative for that reason. Private placements have some benefits for the borrower. First the borrower needs only to report the borrowing on its financial statements. The details of the borrowing can be kept secret. If the investor insists on protective covenants (e.g. minimum EBITDA coverage) 6 these covenants and the companys compliance with them are known only to the company and the investor. Secondly, publicly traded securities entail a significant legal expense to comply with the reporting requirements of the Securities Exchange Commission. Issuing a public bond can be a lengthy, costly process. Private placements are fast. For these reason Maurine Stewart is amenable to the suggestion by the Citibank people that she investigate the private placement market. Indeed, Citibanks customer is prepared to invest a sizable sum as soon as it can access and analyze W F Princes financial statements and other data about the firm. But there is a rub. The pension plan wants unconventionally small cash payments during the life of the contract and then be compensated by a larger final cash flow when the loan matures. The pension plan makes it clear that it expects an overall yield to maturity of 7.25% which seems a little on the high side but still within the realm of reason. But it wants the private placement to have a face value not of $50 million but of $60 million instead. In this case face value refers to the redemption amount not to the initial amount lent by the investor. The amount actually lent by the investor would be the present value of all the cash flows the investor receives discounted at 7.25% compounded semiannually. The coupon rate would be 5.50% and the maturity would be twelve years. In addition, the pension plan produces a document 90 pages long with the details of the covenant to be agreed to by the company including minimum coverage ratios and other restrictions. But, because the private placement is less work and less risky to the investment banker the flotation fee is only 2.00%. To summarize, a. Maturity Twelve years b. Face Value $60,000,000 (the redemption amount) c. Price to Investors The present value of the coupon cash flows and the $60,000,000 discounted at 7.25% compounded semi-annually d. Yield to Maturity 7.25% e. Coupon rate 5.50% f. Flotation Fee 2.00% g. Proceeds to W. F. Prince 98% of the money that the Pension Plan pays up front Q9 How much money will the pension plan pay up front? Here are two hints. a. While you can use $100 bonds it is much easier to use the actual face value of $60,000,000. b. You can still use the bond calculator for this. All you are doing is finding the market price given the coupon rate, the maturity, and the yield to maturity. Q10 What will the proceeds be to W.F. Prince after the 2% flotation fee? 7 Q11 What will the cost of financing through this private placement be? Q12 & Q13. Which of the three alternative should Maurine Stewart choose (Q12) and why (Q13)? These questions are paired together. There are several correct answers to Q12. But once you respond to Q12 you must have a response to Q13 that justifies it. Note on Callable Bonds Callable bonds are strange bonds because there are two possible cash flows. One cash flow is when the issuing company elects not to call the bond and it remains outstanding with investors until maturity and the other when it elects to call the bonds. When interest rates in the market price are higher than the bonds coupon rate investors assume that the company will not call them. And the company probably wont. Why would it call a lowinterest rate bond when interest rates are higher? In this case investors focus on the bonds yield to maturity (YTM). When interest rates in the market are below the bonds coupon rate investors assume that the bonds will be called. This is almost inevitable because the company can borrow funds at low interest rates and use the proceeds to call the bonds. It is the same as refinancing a house at a lower mortgage rate. In this case investors focus on yield to call (YTC). Thus, with callable bonds there are actually four yields to ponder. Investor Point of View Market Interest Rates Low High Relevant Yield Yield to Call (YTC) Yield to Maturity YTM Relevant Term Until Call Date Until Maturity Redemption Amount Face Value + Call Premium (100% + C%) Face Value 100% Price Issue or Market Price Issue or Market Price 8 Borrower Point of View Market Interest Rates Low High Relevant Yield Yield to Call (YTC) Yield to Maturity YTM Relevant Term Until Call Date Until Maturity Redemption Amount Face Value + Call Premium (100% + C%) Face Value 100% Issue Price Face Value (1- F%) Face Value (1- F%)