Suppose a new company decides to raise a total of $200 million, with $100 million as common equity and $100 million as long-term debt. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT?
a. The higher the percentage of debt represented by mortgage bonds, the risker both types of bonds wii be and, consequently, the higher the firm's total dollar interest charges will be.
b. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of debentures.
c. In this situation, we cannot tell for sure how, or whether, the firm's total interest expenses on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two.
d. The higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures.
e. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.
Could you explain why the other answers would work?
Could you explain why the other answers wouldnt work?
To determine the correct answer, let's analyze the statements one by one:
a. The statement suggests that the higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be, and consequently, the firm's total dollar interest charges will be higher. However, this statement is incorrect. The risk of a bond depends on various factors such as the creditworthiness of the issuer, market conditions, and economic factors. The type of bond (mortgage bond or debenture) alone does not determine its risk. Additionally, the interest charges would depend on the interest rates associated with each type of bond.
b. The statement implies that if the debt was raised by issuing $50 million of debentures and $50 million of first mortgage bonds, the firm's total interest expense would be lower than if the debt was raised by issuing $100 million of debentures. However, this statement is incorrect. The interest expense depends on the interest rates associated with each type of bond, not just the division of debt between debentures and first mortgage bonds.
c. The statement suggests that we cannot determine how the mix of debentures versus first mortgage bonds would affect the firm's total interest expenses. It states that the interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased. However, it also suggests that the firm's total interest charges may not be materially affected by the mix. This statement is correct. Without specific information about the interest rates and other factors, we cannot conclusively determine the impact of the mix on the firm's total interest expenses.
d. The statement states that the higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures. However, this statement is incorrect. The risk borne by each debenture depends on various factors, not just the percentage of debentures issued. The required rate of return depends on the risk associated with the specific debenture, not just the composition of debt.
e. The statement claims that if the debt was raised by issuing $50 million of debentures and $50 million of first mortgage bonds, the firm's total interest expense would be lower than if the debt was raised by issuing $100 million of first mortgage bonds. However, this statement is incorrect. The interest expense would depend on the specific interest rates associated with each type of bond, not just the division of debt between debentures and first mortgage bonds.
In conclusion, the only correct statement is:
c. In this situation, we cannot tell for sure how, or whether, the firm's total interest expenses on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two.