Credit valuation question

Alicia Quan is an analyst for a mutual fund that owns some high-yield bonds issued by AQT Corporation. The following table shows AQT’s simplified balance sheet. Amounts are in millions of dollars. Total assets 1,000 Current liabilities 200 Long-term debt 300 Equity 500 The long-term debt includes high-yield bonds, some of which are owned by the mutual fund. AQT is planning to embark on a new project that requires additional capitalization of $200 million. It is not clear how AQT plans to fund the new project. It may issue more stocks and possibly more bonds. Alicia is concerned that, if AQT decides to issue additional bonds, the higher debt ratios would cause the existing high-yield bonds to go down in value. The high-yield bonds include a negative covenant that puts a limit on additional indebtedness unless certain ratios are met. One such ratio is the long-term debt to total capitalization, which must be less than 45%. If AQT were to fund the new project by issuing additional bonds, the long-term debt to total assets ratio would be 16.7% 41.7% 50.0% 58.3%. If AQT were to fund the new project by issuing stocks, the long-term debt to equity ratio would be 30.0% 42.9% 60.0% 71.4%. Alicia is confident that the following cannot happen AQT funds the new project using all stocks AQT funds the new project using all bonds AQT funds the new project using stocks and bonds AQT funds the new project using stocks and syndicated bank loans. Alicia is concerned that the high-yield bonds may drop in value if the new project is capitalized in a way that is detrimental to existing bondholders. She can hedge this risk by shorting Treasury bond futures buying put options on AQT stocks monitoring closely the news from AQT corporate headquarters none of the above. To understand the interest rate risk of the high-yield bonds, Alicia would need the modified duration the effective duration the convexity or effective convexity the nominal spread or zero-volatility spread.

50%, 42.9%, all bond, none of the above, effective duration? I actually was just about to move to some FI to close out my night. I haven’t studied FI nearly enough as I should.

Banny, your right on all except the first one. It should be 500/1200 = 0.417%

oooh, cause of the new purch, right.

yea, the purchase increases their assets but the amount that their debt increases.

hmm I can not really folllow why can it not be funded by all bonds, the ratio ends up to 41.7 ie under 45. Thanks!

The ratio that must be under 45 is LTD / Capital Inv not LTD / Total Assets

… as always half the battle is to read the questions.

but isnt total capitalisation => CL + LTd + Equity which = Total Assets?? ok?

No, Inc cap does not equal total assets

Then what is total cap?

Total Cap = LTD + (Pref + Common) Equity

You also need to add minority interest and capitalize operating lease if it is given for total CAP. For the last question if bond does not have option, modified duration is also Ok? But effective duration is safer, it should work.