Bill Bates is the CFO of Madison Company and is evaluating the debt structure of the firm, which currently comprises Issues A and B in the following table. Issue Issue Date Coupon Principal Maturity Yield A 1/01/X1 8% 100,000 4 years 6% B 6/30/X1 0% 200,000 2 years 7% Madison wants to raise an additional $300,000 and is considering issuing Bond C. If Madison’s goal is to maximize operating cash flow and minimize its debt to equity ratio, which of the following would most likely meet all of these objectives? a. Issue a $300,000 coupon bond at par. b. Issue a $300,000 coupon bond at par with warrants. c. Issue a $300,000 zero-coupon bond. d. Issue a $300,000 convertible bond at par. - Dinesh S
The only way to issue a Bond and then reduce the debt/equity ratio - would in my mind be to issue coupon bond at par with warrants. ( I might be burnt to say that)…on the forum I would guess B
B because of the lack of cupons then cfo is higher and the warrants work towards lowering the debt equity ratio
you guys are never wrong, B is the correct answer. But it’s not so intuitive for people like us who are having a first time look at finance. So it’s safe to assume this will always be the case? - Dinesh S
sorry the first part of my answer is wrong thought it was 0 cupon with warrants
warrants will allow for a smaller cupon because it is considered a sweetner so the cfo will be higher
yes, since warrants are a sweetner, the general public needs to be compensated less for holiding such a combo. So bondissuers can safely reduce the coupon payments, thus lowering the coupon interest expense, and thus improving the CFO, also warrants are a part of equity so D/E ratio will fall, as E has increased in the denominator… is my understanding correct, florinpop ? -Dinesh S
I would assume, I am not on top of my game on bonds, just started book 5. but that is also my understanding. Probably it would have been more clear if the bonds weren’t restricted to being issued at par
Would D be wrong due to having to pay a higher coupon than that of issue B?
D would be wrong because the converstion is not a guarantee so equity would not necessarily increase. B is right because warrants automatically increase equity.
I believe the effects on equity are the same for warrants and convertible bonds (unless they are contingent convertibles and I’m not current on the GAAP status of those). But the coupon rate will be lower on the bond with detachable warrants than the convert because it provides the investor with more options. If the company does really well, both the bond and the warrant increase in value and you can get stock while keeping your valuable bond.