Chapter 24/Debt Financing

69

Chapter 24

Debt Financing
24-1.

Explain some of the differences between a public debt offering and a private debt offering.
In a public debt offering, a prospectus is created with details of the offering and a formal contract
between the bond issuer and the trust company is signed. The trust company makes sure the terms of
the contract are enforced. In a private offering there is no need for a prospectus or a formal contract.
Instead, a promissory note can be enough. Moreover, the contract in a private placement does not have
to be standard.

24-2.

Why do bonds with lower seniority have higher yields than equivalent bonds with higher
seniority?
Requiring coupon payments protects the bondholders from waiting a long time in case the debtor
defaults. Without coupon payments, default only happens when the bond matures, but by then the
corporation might have depleted all of its assets. In contrast, with coupon payments the debtor would
be in default the moment it misses one of the coupon payments, and the bondholders can then force the
firm into bankruptcy. At this stage, they might be able to get a larger fraction of the value of the
original debt than if they waited until maturity.

24-3.

Explain the difference between a secured corporate bond and an unsecured corporate bond.
A secured corporate bond gives the bondholder the right over particular assets that serve as collateral in
case of default. An unsecured corporate bond does not offer such protection to the bondholder. Thus,
with an unsecured corporate bond, the bondholders are residual claimants in the case of bankruptcy
after the secured assets have been given to the corresponding bondholders.

24-4.

What is the difference between a foreign bond and a Eurobond?

A foreign bond is a bond issued by a foreign company in a local market. Eurobonds, on the other hand,
are bonds denominated in a different currency than the country in which they are issued.

24-5.

Describe the kinds of securities the U.S. government uses to finance the federal debt.
The U.S. government uses treasury bills, note, bonds, and TIPS. Treasury bills are pure discount bonds
with maturities of one year or less. Treasury notes are coupon bonds with semi-annual coupon
payments with maturities between 1 and 10 years. Treasury bonds are semi-annual coupon bonds with
maturities longer than 10 years. Finally, TIPS are bonds with coupon payments that adjust with the rate
of inflation. The final payment is protected against deflation since the value of the final payment is the
maximum between the face value and the inflation adjusted face value.

24-6.

On January 15, 2010, the U.S. Treasury issued a five-year inflation-indexed note with a coupon of
3%. On the date of issue, the consumer price index (CPI) was 250. By January 15, 2015, the CPI
had increased to 300. What principal and coupon payment was made on January 15, 2015?

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70

Berk/DeMarzo, Corporate Finance, Global Edition, Third Edition

The CPI index appreciated by:

300
1.2.
250

Consequently, the principal amount of the bond increased by this amount; that is, the original face
value of $1,000 increased to $1,200.
Since the bond pays semi-annual coupons, the coupon payment is:

0.03
$1, 000 $18.
2

1.2
24-7.

On January 15, 2020, the U.S. Treasury issued a 10-year inflation-indexed note with a coupon of
6%. On the date of issue, the CPI was 400. By January 15, 2030, the CPI had decreased to 300.
What principal and coupon payment was made on January 15, 2030?
The CPI index depreciated by
300
0.75.
400

Consequently, the principal amount of the bond decreased by this amount; that is, the original face
value of $1,000 decreased to $750.
Since the bond pays semi-annual coupons, the coupon payment is:

0.06
$1, 000 $22.5.
2

0.75

However, the final payment of the maturity (i.e. the principal) is protected against deflation. So since
$750 is less than the original face value of $1,000, the original mount is repaid, i.e. $1,000.
24-8.

Describe what prepayment risk in a GNMA is.

Holders of the GNMA securities face payment risk because homeowners have the option to prepay
their debt whenever they decide to do so. In particular, they will prepay if interest rates fall and they
can obtain new debt at a lower interest rate. This is precisely when the holders of GNMA securities
would like to avoid payments, since they can only reinvest at a lower interest rate.

24-9.

What is the distinguishing feature of how municipal bonds are taxed?

The distinguishing feature is that income from municipal bonds is not taxed at the federal level.

24-10.

Explain why bond issuers might voluntarily choose to put restrictive covenants into a new bond
issue.
Bond issuers benefit from placing restricting covenants because by doing so they can obtain a lower
interest rate.

24-11.

General Electric has just issued a callable 10-year, 6% coupon bond with annual coupon
payments. The bond can be called at par in one year or anytime thereafter on a coupon payment
date. It has a price of $102. What is the bonds yield to maturity and yield to call?
Timeline:
Time

Cash Flows

10

$6

$6

$6

$100
+ $6

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Chapter 24/Debt Financing

71

The present value formula to e solved is:

102

6
1
100
1

10
YTM
1 YTM 1 YTM 10

Using the annuity calculator:

YTM 5.73%
YTC:
Timeline:
Time

Cash Flows

$100
+ $6

The present value formula to be solved is:

102

106
1 YTC

YTC
24-12.

106
1 3.92%.
102

Boeing Corporation has just issued a callable (at par) three-year, 5% coupon bond with
semiannual coupon payments. The bond can be called at par in two years or anytime thereafter
on a coupon payment date. It has a price of $99. What is the bonds yield to maturity and yield to
call?
Timeline:
Years
Periods

0
0

Cash Flows

1
2

2
4

$2.5

$2.5

$2.5

$2.5

$2.5

The present value formula to be solved is:

99

2.5
1
100
1

.
6

i
1 i 1 i 6

Using the annuity calculator:

i 2.68%.

So since YTM are quoted as APRs:

YTM i 2 2.68% 2 5.36%.

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3
6

$100
+ $2.5

72

Berk/DeMarzo, Corporate Finance, Global Edition, Third Edition

YTC:
Timeline:
Years
Periods

0
0

Cash Flows

1
2

$2.5

$2.5

$2.5

2
4

$100
+ $2.5

The present value formula to be solved is:

99

2.5
1
100
1

.
4
4
i
1 i 1 i

Using the annuity calculator:

i 2.77%.

Since YTM (and therefore YTC) are quoted as APRs:

YTC i 2
5.54%.
24-13.

Explain why the yield on a convertible bond is lower than the yield on an otherwise identical
bond without a conversion feature.
The option to convert the bond into stock is valuable, hence its price will be higher and its yield lower.

24-14.

You own a bond with a face value of $10,000 and a conversion ratio of 450. What is the
conversion price?
The conversion price is the face value of the bond divided by the conversion ratio. In this case:
P

Face value
$10, 000

Conversion ratio
450

P $22.22.

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