1) A company wishes to issues bonds with a coupon rate of 5%. The company wishes to raise 100 million dollars net of commissions (5% of total sales). Each bond has a face value of $1,000 and matures in 10 years. Interest is to be paid semi-annually. Using the following conditions, please determine how many bonds the company has to sell in order to raise the necessary capital:
a. 8% market
b. 5% market
c. 4% market
If the company has an effective income tax rate of 30%, how does this influence the decision making? Be specific and show calculations. What would be the effective after tax interest rate? What critical ratios does the issues of bonds change and how? You must use excel and the formula menu for the time-value calculation.
To determine how many bonds the company needs to sell to raise the necessary capital, we can start by calculating the total sales required.
a) When the market interest rate is 8%:
Since the coupon rate of the bonds is 5%, the bonds will be issued at a discount. We can calculate the present value of the required capital using the market interest rate of 8%.
PV = $100 million / (1 + 8%/2)^20
PV = $57,608,935.78
The present value represents the total sales required after deducting commissions.
To find the number of bonds, divide the present value by the face value of each bond:
Number of bonds = PV / $1,000
Number of bonds = $57,608,935.78 / $1,000
Number of bonds = 57,609 bonds
b) When the market interest rate is 5%:
Using the same logic, we can calculate the present value:
PV = $100 million / (1 + 5%/2)^20
PV = $79,177,559.58
Number of bonds = PV / $1,000
Number of bonds = $79,177,559.58 / $1,000
Number of bonds = 79,178 bonds
c) When the market interest rate is 4%:
Again, we calculate the present value:
PV = $100 million / (1 + 4%/2)^20
PV = $89,226,321.67
Number of bonds = PV / $1,000
Number of bonds = $89,226,321.67 / $1,000
Number of bonds = 89,226 bonds
Now let's consider the impact of the effective income tax rate of 30% on the decision-making process.
To calculate the after-tax interest rate, we use the formula:
After-tax interest rate = Market interest rate × (1 - Effective tax rate)
a) After-tax interest rate at the 8% market:
After-tax interest rate = 8% × (1 - 30%)
After-tax interest rate = 5.6%
b) After-tax interest rate at the 5% market:
After-tax interest rate = 5% × (1 - 30%)
After-tax interest rate = 3.5%
c) After-tax interest rate at the 4% market:
After-tax interest rate = 4% × (1 - 30%)
After-tax interest rate = 2.8%
The critical ratios impacted by issuing bonds are the debt-to-equity ratio and interest coverage ratio.
The debt-to-equity ratio is impacted because issuing bonds increases the company's liabilities (debt) without affecting equity.
The interest coverage ratio is also impacted because the company now has additional interest obligations due to the bonds issued. This ratio shows the company's ability to cover its interest expenses with its operating income.
Overall, issuing bonds increases the company's debt and interest obligations, which affects its financial leverage and can have implications for its risk profile and creditworthiness.