CHAPTER
8
B o nd s a nd T he i r Va l ua t io n
SOURCE: Courtesy of Ford Motor Company
48
FORD’S BOND
ISSUE SETS
A NEW RECORD
$
FORD MOTOR COMPANY
D
uring the summer of 1999 the future course of
interest rates was highly uncertain. Continued
Top Ten U.S. Corporate Bond Financings
as of July 1999
strength in the economy and growing fears of
inflation had caused interest rates to rise, and many
AMOUNT
(BILLIONS
OF DOLLARS)
ISSUER
DATE
Ford
July 9, 1999
AT&T
March 23, 1999
8.00
RJR Holdings
May 12, 1989
6.11
WorldCom
August 6, 1998
6.10
Sprint
November 10, 1998
5.00
companies tended to postpone bond issues out of fear that
Assoc. Corp. of
N. America
October 27, 1998
4.80
nervous investors would be unwilling to purchase them.
Norfolk Southern May 14, 1997
4.30
US West
January 16, 1997
4.10
found itself in June 1999, when it decided to put a
Conoco
April 15, 1999
4.00
large debt issue on hold. However, after just three
Charter
Communications
March 12, 1999
3.58
analysts were concerned that this trend would continue.
However, others were forecasting declining rates — they
saw no threat from inflation and were more concerned
about the economy running out of gas. Because of this
uncertainty, bond investors tended to wait on the sidelines
for some definitive economic news. At the same time,
This is exactly the situation in which Ford Motor
weeks, Ford sensed a shift in the investment climate,
$8.60
and it announced plans for an $8.6 billion bond issue.
As shown in the following table, the Ford issue set a
new record, surpassing an $8 billion AT&T issue that had
taken place a few months earlier.
Ford’s $8.6 billion issue actually consisted of four
SOURCE: Thomson Financial Securities Data, Credit Suisse
First Boston as reported in The Wall Street Journal, July 12,
1999, C1.
Most analysts agreed that these bonds had limited
separate bonds. Ford Credit, a subsidiary that provides
default risk. At the time, Ford held $24 billion in cash
customer financing, borrowed $1.0 billion dollars at a
and had earned a record $2.5 billion during the second
two-year floating rate and another $1.8 billion at a
quarter of 1999. However, the auto industry faces some
three-year floating rate. Ford Motor itself borrowed $4
inherent risks. When all the risk factors were balanced,
billion as five-year fixed-rate debt and another $1.8
the issues all received a single-A rating. Much to the
billion at a 32-year fixed rate.
relief of the jittery bond market, the Ford issue was well
349
received. Dave Cosper, Ford Credit’s Treasurer, said
bonds outstanding will decrease, forcing many Treasury
“There was a lot of excitement, and demand exceeded
investors into the corporate bond market, where they
our expectations.”
will look for investment-grade issues by companies such
The response to the Ford offering revealed that
investors had a strong appetite for large bond issues
as Ford.
Already anticipating this demand, Ford is planning
with strong credit ratings. Larger issues are more liquid
to regularly issue large blocks of debt in the global
than smaller ones, and liquidity is particularly important
market. Seeing Ford’s success, less than one month
to bond investors when the direction of the overall
after the Ford issue, Wal-Mart entered the list of top
market is highly uncertain.
ten U.S. corporate bond financings with a new $5
Interestingly, large investment-grade issues by wellknown companies such as Ford are also helping to fill
billion issue. Other large companies have subsequently
followed suit. ■
the vacuum created by the reduction in Treasury debt.
The Federal government is forecasting future budget
surpluses, and it plans to use a portion of the surplus to
SOURCE: Gregory Zuckerman, “Ford’s Record Issue May Drive
Imitators,” The Wall Street Journal, July 12, 1999, C1.
reduce its outstanding debt. As this occurs, Treasury
Bonds are one of the most important types of securities. If you skim through The
Wall Street Journal, you will see references to a wide variety of these securities.
This variety may seem confusing, but in actuality just a few characteristics distinguish the various types of bonds.
While bonds are often viewed as relatively safe investments, one can certainly
lose money on them. Indeed, “riskless” long-term U.S. Treasury bonds have declined in value three of the last seven years. Note, though, that it is also possible to rack up impressive gains in the bond market. Long-term government bonds
provided a total return of nearly 16 percent in 1997 and more than 30 percent in
1995.
In this chapter, we will discuss the types of bonds companies and government
agencies issue, the terms that are contained in bond contracts, the types of risks
to which both bond investors and issuers are exposed, and procedures for determining the values of and rates of return on bonds.
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■
WHO ISSUES BONDS?
Bond
A long-term debt instrument.
Treasury Bonds
Bonds issued by the federal
government, sometimes referred
to as government bonds.
Corporate Bonds
Bonds issued by corporations.
Municipal Bonds
Bonds issued by state and local
governments.
Foreign Bonds
Bonds issued by either
foreign governments or
foreign corporations.
A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond.
For example, on January 3, 2002, Allied Food Products borrowed $50 million
by issuing $50 million of bonds. For convenience, we assume that Allied sold
50,000 individual bonds for $1,000 each. Actually, it could have sold one $50
million bond, 10 bonds with a $5 million face value, or any other combination
that totals to $50 million. In any event, Allied received the $50 million, and in
exchange it promised to make annual interest payments and to repay the $50
million on a specified maturity date.
Investors have many choices when investing in bonds, but bonds are classified into four main types: Treasury, corporate, municipal, and foreign. Each
type differs with respect to expected return and degree of risk.
Treasury bonds, sometimes referred to as government bonds, are issued by
the federal government.1 It is reasonable to assume that the federal government
will make good on its promised payments, so these bonds have no default risk.
However, Treasury bond prices decline when interest rates rise, so they are not
free of all risks.
Corporate bonds, as the name implies, are issued by corporations. Unlike
Treasury bonds, corporate bonds are exposed to default risk — if the issuing
company gets into trouble, it may be unable to make the promised interest and
principal payments. Different corporate bonds have different levels of default
risk, depending on the issuing company’s characteristics and on the terms of the
specific bond. Default risk is often referred to as “credit risk,” and, as we saw in
Chapter 5, the larger the default or credit risk, the higher the interest rate the
issuer must pay.
Municipal bonds, or “munis,” are issued by state and local governments.
Like corporate bonds, munis have default risk. However, munis offer one major
advantage over all other bonds: As we discussed in Chapter 2, the interest
earned on most municipal bonds is exempt from federal taxes and also from
state taxes if the holder is a resident of the issuing state. Consequently, municipal bonds carry interest rates that are considerably lower than those on corporate bonds with the same default risk.
Foreign bonds are issued by foreign governments or foreign corporations.
Foreign corporate bonds are, of course, exposed to default risk, and so are some
foreign government bonds. An additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency. For example, if you purchase corporate bonds denominated in Japanese yen, you will lose
money — even if the company does not default on its bonds — if the Japanese
yen falls relative to the dollar.
1
The U.S. Treasury actually calls its debt issues “bills,” “notes,” or “bonds.” T-bills generally have
maturities of 1 year or less at the time of issue, notes generally have original maturities of 2 to 7 years,
and bond maturities extend out to 30 years. There are technical differences between bills, notes, and
bonds, but they are not important for our purposes, so we generally call all Treasury securities
“bonds.” Note too that a 30-year T-bond at the time of issue becomes a 1-year bond 29 years later.
WHO ISSUES BONDS?
351
An excellent site for
information on many types
of bonds is Bonds Online,
which can be found at
http://www.
bondsonline.com. The site has a great
deal of information about corporates,
municipals, treasuries, and bond funds.
It includes free bond searches, through
which the user specifies the attributes
desired in a bond and then the search
returns the publicly traded bonds
meeting the criteria. The site also
includes a downloadable bond calculator
and an excellent glossary of bond
terminology.
SELF-TEST QUESTIONS
What is a bond?
What are the four main types of bonds?
Why are U.S. Treasury bonds not riskless?
To what types of risk are investors of foreign bonds exposed?
KEY CHARACTERISTICS OF BONDS
Although all bonds have some common characteristics, they do not always
have the same contractual features. For example, most corporate bonds have
provisions for early repayment (call features), but these provisions can be quite
different for different bonds. Differences in contractual provisions, and in the
underlying strength of the companies backing the bonds, lead to major differences in bonds’ risks, prices, and expected returns. To understand bonds, it is
important that you understand the following terms.
PA R VA L U E
Par Value
The par value is the stated face value of the bond; for illustrative purposes we
generally assume a par value of $1,000, although any multiple of $1,000 (for example, $5,000) can be used. The par value generally represents the amount of
money the firm borrows and promises to repay on the maturity date.
The face value of a bond.
C O U P O N I N T E R E S T R AT E
Coupon Payment
The specified number of dollars of
interest paid each period,
generally each six months.
Coupon Interest Rate
The stated annual interest rate on
a bond.
Allied’s bonds require the company to pay a fixed number of dollars of interest
each year (or, more typically, each six months). When this coupon payment,
as it is called, is divided by the par value, the result is the coupon interest rate.
For example, Allied’s bonds have a $1,000 par value, and they pay $100 in interest each year. The bond’s coupon interest is $100, so its coupon interest rate
is $100/$1,000 ! 10 percent. The $100 is the yearly “rent” on the $1,000 loan.
This payment, which is fixed at the time the bond is issued, remains in force
during the life of the bond.2 Typically, at the time a bond is issued, its coupon
payment is set at a level that will enable the bond to be issued at or near its par
2
Incidentally, some time ago bonds literally had a number of small (1/2- by 2-inch), dated coupons
attached to them, and on each interest payment date, the owner would clip off the coupon for that
date and either cash it at his or her bank or mail it to the company’s paying agent, who would then
mail back a check for the interest. A 30-year, semiannual bond would start with 60 coupons,
whereas a 5-year annual payment bond would start with only 5 coupons. Today, new bonds must
be registered — no physical coupons are involved, and interest checks are mailed automatically to
the registered owners of the bonds. Even so, people continue to use the terms coupon and coupon interest rate when discussing registered bonds.
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Floating Rate Bond
A bond whose interest rate
fluctuates with shifts in the
general level of interest rates.
Zero Coupon Bond
A bond that pays no annual
interest but is sold at a discount
below par, thus providing
compensation to investors in the
form of capital appreciation.
Original Issue Discount Bond
Any bond originally offered at a
price below its par value.
Maturity Date
A specified date on which the par
value of a bond must be repaid.
Original Maturity
The number of years to maturity
at the time a bond is issued.
value. Consequently, most of our examples and problems throughout this text
will focus on bonds with fixed coupon rates.
In some cases, however, a bond’s coupon payment will vary over time. These
floating rate bonds work as follows. The coupon rate is set for, say, the initial
six-month period, after which it is adjusted every six months based on some
market rate. Some corporate issues are tied to the Treasury bond rate, while
other issues are tied to other rates. Many additional provisions can be included
in floating rate issues. For example, some are convertible to fixed rate debt,
whereas others have upper and lower limits (“caps” and “floors”) on how high
or low the rate can go.
Floating rate debt is popular with investors who are worried about the risk of
rising interest rates, since the interest paid increases whenever market rates rise.
This causes the market value of the debt to be stabilized, and it also provides institutional buyers such as banks with income that is better geared to their own
obligations. Banks’ deposit costs rise with interest rates, so the income on floating rate loans that they have made rises at the same time their deposit costs are
rising. The savings and loan industry was virtually destroyed as a result of their
practice of making fixed rate mortgage loans but borrowing on floating rate
terms. If you are earning 6 percent but paying 10 percent — which they were —
you soon go bankrupt — which they did.
Moreover, floating rate debt appeals to corporations that want to issue longterm debt without committing themselves to paying an historically high interest
rate for the entire life of the loan.
Some bonds pay no coupons at all, but are offered at a substantial discount
below their par values and hence provide capital appreciation rather than interest income. These securities are called zero coupon bonds (“zeros”). Other
bonds pay some coupon interest, but not enough to be issued at par. In general,
any bond originally offered at a price significantly below its par value is called
an original issue discount (OID) bond. Corporations first used zeros in a
major way in 1981. In recent years IBM, Alcoa, JCPenney, ITT, Cities Service,
GMAC, Lockheed Martin, and even the U.S. Treasury have used zeros to raise
billions of dollars. Some of the details associated with issuing or investing in
zero coupon bonds are discussed more fully in Appendix 8A.
M AT U R I T Y D AT E
Bonds generally have a specified maturity date on which the par value must be
repaid. Allied’s bonds, which were issued on January 3, 2002, will mature on
January 2, 2017; thus, they had a 15-year maturity at the time they were issued.
Most bonds have original maturities (the maturity at the time the bond is issued) ranging from 10 to 40 years, but any maturity is legally permissible.3 Of
course, the effective maturity of a bond declines each year after it has been issued. Thus, Allied’s bonds had a 15-year original maturity, but in 2003, a year
later, they will have a 14-year maturity, and so on.
3
In July 1993, Walt Disney Co., attempting to lock in a low interest rate, issued the first 100-year
bonds to be sold by any borrower in modern times. Soon after, Coca-Cola became the second company to stretch the meaning of “long-term bond” by selling $150 million worth of 100-year bonds.
KEY CHARACTERISTICS OF BONDS
353
CALL PROVISIONS
Call Provision
A provision in a bond contract
that gives the issuer the right to
redeem the bonds under specified
terms prior to the normal
maturity date.
Most corporate bonds contain a call provision, which gives the issuing corporation the right to call the bonds for redemption.4 The call provision generally
states that the company must pay the bondholders an amount greater than the
par value if they are called. The additional sum, which is termed a call premium,
is often set equal to one year’s interest if the bonds are called during the first
year, and the premium declines at a constant rate of INT/N each year thereafter, where INT ! annual interest and N ! original maturity in years. For example, the call premium on a $1,000 par value, 10-year, 10 percent bond would
generally be $100 if it were called during the first year, $90 during the second
year (calculated by reducing the $100, or 10 percent, premium by one-tenth),
and so on. However, bonds are often not callable until several years (generally
5 to 10) after they were issued. This is known as a deferred call, and the bonds
are said to have call protection.
Suppose a company sold bonds when interest rates were relatively high. Provided the issue is callable, the company could sell a new issue of low-yielding
securities if and when interest rates drop. It could then use the proceeds of the
new issue to retire the high-rate issue and thus reduce its interest expense. This
process is called a refunding operation.
The call privilege is valuable to the firm but potentially detrimental to the
investor, especially if the bonds were issued in a period when interest rates were
cyclically high. Accordingly, the interest rate on a new issue of callable bonds
will exceed that on a new issue of noncallable bonds. For example, on August
30, 2001, Pacific Timber Company sold a bond issue yielding 9.5 percent; these
bonds were callable immediately. On the same day, Northwest Milling Company sold an issue of similar risk and maturity yielding 9.2 percent; its bonds
were noncallable for 10 years. Investors were willing to accept a 0.3 percent
lower interest rate on Northwest’s bonds for the assurance that the 9.2 percent
interest rate would be earned for at least 10 years. Pacific, on the other hand,
had to incur a 0.3 percent higher annual interest rate to obtain the option of
calling the bonds in the event of a decline in rates.
SINKING FUNDS
Sinking Fund Provision
A provision in a bond contract
that requires the issuer to retire a
portion of the bond issue each
year.
Some bonds also include a sinking fund provision that facilitates the orderly
retirement of the bond issue. On rare occasions the firm may be required to deposit money with a trustee, which invests the funds and then uses the accumulated sum to retire the bonds when they mature. Usually, though, the sinking
fund is used to buy back a certain percentage of the issue each year. A failure to
meet the sinking fund requirement causes the bond to be thrown into default,
which may force the company into bankruptcy. Obviously, a sinking fund can
constitute a significant cash drain on the firm.
In most cases, the firm is given the right to handle the sinking fund in either
of two ways:
4
A majority of municipal bonds also contain call provisions. Call provisions have been included
with Treasury bonds, although this occurs less frequently.
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B O N D S A N D T H E I R VA L U AT I O N
1. The company can call in for redemption (at par value) a certain percentage of the bonds each year; for example, it might be able to call 5 percent
of the total original amount of the issue at a price of $1,000 per bond.
The bonds are numbered serially, and those called for redemption are determined by a lottery administered by the trustee.
2. The company may buy the required number of bonds on the open
market.
The firm will choose the least-cost method. If interest rates have risen, causing
bond prices to fall, it will buy bonds in the open market at a discount; if interest rates have fallen, it will call the bonds. Note that a call for sinking fund purposes is quite different from a refunding call as discussed above. A sinking fund
call typically requires no call premium, but only a small percentage of the issue
is normally callable in any one year.5
Although sinking funds are designed to protect bondholders by ensuring
that an issue is retired in an orderly fashion, you should recognize that sinking
funds can work to the detriment of bondholders. For example, suppose the
bond carries a 10 percent interest rate, but yields on similar bonds have fallen
to 7.5 percent. A sinking fund call at par would require an investor to give up a
bond that pays $100 of interest and then to reinvest in a bond that pays only
$75 per year. This obviously disadvantages those bondholders whose bonds are
called. On balance, however, bonds that have a sinking fund are regarded as
being safer than those without such a provision, so at the time they are issued
sinking fund bonds have lower coupon rates than otherwise similar bonds without sinking funds.
O T H E R F E AT U R E S
Convertible Bond
A bond that is exchangeable, at
the option of the holder, for
common stock of the issuing firm.
Warrant
A long-term option to buy a stated
number of shares of common
stock at a specified price.
Income Bond
A bond that pays interest only if
the interest is earned.
Indexed (Purchasing Power)
Bond
A bond that has interest payments
based on an inflation index so as
to protect the holder from
inflation.
Several other types of bonds are used sufficiently often to warrant mention.
First, convertible bonds are bonds that are convertible into shares of common
stock, at a fixed price, at the option of the bondholder. Convertibles have a
lower coupon rate than nonconvertible debt, but they offer investors a chance
for capital gains in exchange for the lower coupon rate. Bonds issued with warrants are similar to convertibles. Warrants are options that permit the holder
to buy stock for a stated price, thereby providing a capital gain if the price of
the stock rises. Bonds that are issued with warrants, like convertibles, carry
lower coupon rates than straight bonds.
Another type of bond is an income bond, which pays interest only if the interest is earned. Thus, these securities cannot bankrupt a company, but from an
investor’s standpoint they are riskier than “regular” bonds. Yet another bond is
the indexed, or purchasing power, bond, which first became popular in
Brazil, Israel, and a few other countries plagued by high inflation rates. The interest rate paid on these bonds is based on an inflation index such as the consumer price index, so the interest paid rises automatically when the inflation
rate rises, thus protecting the bondholders against inflation. In January 1997,
the U.S. Treasury began issuing indexed bonds, and 10-year indexed bonds
currently pay a real rate that is roughly 3.5 percent plus the rate of inflation.
5
Some sinking funds require the issuer to pay a call premium.
KEY CHARACTERISTICS OF BONDS
355
We used the term “i” or “I” to designate the interest rate in Chapter 7
because those terms are used on financial calculators, but “k,” with the
subscript “d” to designate the rate on a debt security, is normally used
in finance.6
N ! the number of years before the bond matures ! 15. Note that N declines each year after the bond has been issued, so a bond that had a
maturity of 15 years when it was issued (original maturity ! 15) will
have N ! 14 after one year, N ! 13 after two years, and so on. Note
also that at this point we assume that the bond pays interest once a
year, or annually, so N is measured in years. Later on, we will deal with
semiannual payment bonds, which pay interest each six months.
INT ! dollars of interest paid each year ! Coupon rate " Par value !
0.10($1,000) ! $100. In calculator terminology, INT ! PMT ! 100.
If the bond had been a semiannual payment bond, the payment would
have been $50 each six months. The payment would be zero if Allied
had issued zero coupon bonds, and it would vary if the bond was a
“floater.”
M ! the par, or maturity, value of the bond ! $1,000. This amount must be
paid off at maturity.
We can now redraw the time line to show the numerical values for all variables
except the bond’s value:
0
10%
Bond’s Value
1
2
3
100
100
100
. . .
15
100
1,000
1,100
The following general equation can be solved to find the value of any bond:
Bond's value ! VB !
INT
INT
INT
M
#
# ####
#
1
2
N
(1 # kd)
(1 # kd)
(1 # kd)
(1 # kd)N
N
INT
M
! a
.
t #
(1
#
k
)
(1
#
kd)N
d
t!1
(8-1)
Equation 8-1 can also be rewritten for use with the tables:
VB ! INT(PVIFAkd,N) # M(PVIFkd,N).
(8-2)
Inserting values for our particular bond, we have
15
$1,000
$100
VB ! a
t #
(1.10)15
t!1 (1.10)
! $100(PVIFA10%,15) # $1,000(PVIF10%,15).
Note that the cash flows consist of an annuity of N years plus a lump sum
payment at the end of Year N, and this fact is reflected in Equations 8-1 and
8-2. Further, Equation 8-1 can be solved by the four procedures discussed in
6
The appropriate interest rate on debt securities was discussed in Chapter 5. The bond’s riskiness,
liquidity, and years to maturity, as well as supply and demand conditions in the capital markets, all
influence the interest rate on bonds.
B O N D VA L U AT I O N
357
Indenture
A formal agreement between the
issuer of a bond and the
bondholders.
All mortgage bonds are subject to an indenture, which is a legal document
that spells out in detail the rights of both the bondholders and the corporation.
The indentures of many major corporations were written 20, 30, 40, or more
years ago. These indentures are generally “open ended,” meaning that new
bonds can be issued from time to time under the same indenture. However, the
amount of new bonds that can be issued is virtually always limited to a specified
percentage of the firm’s total “bondable property,” which generally includes all
land, plant, and equipment.
For example, in the past Savannah Electric Company had provisions in its
bond indenture that allowed it to issue first mortgage bonds totaling up to 60
percent of its fixed assets. If its fixed assets totaled $1 billion, and if it had $500
million of first mortgage bonds outstanding, it could, by the property test, issue
another $100 million of bonds (60% of $1 billion ! $600 million).
At times, Savannah Electric was unable to issue any new first mortgage
bonds because of another indenture provision: its times-interest-earned (TIE)
ratio was below 2.5, the minimum coverage that it must have if it sells new
bonds. Thus, although Savannah Electric passed the property test, it failed the
coverage test, so it could not issue any more first mortgage bonds. Savannah
Electric then had to finance with junior bonds. Since first mortgage bonds carried lower rates of interest than junior long-term debt, this restriction was a
costly one.
Savannah Electric’s neighbor, Georgia Power Company, had more flexibility
under its indenture — its interest coverage requirement was only 2.0. In hearings before the Georgia Public Service Commission, it was suggested that Savannah Electric should change its indenture coverage to 2.0 so that it could
issue more first mortgage bonds. However, this was simply not possible — the
holders of the outstanding bonds would have to approve the change, and it is
inconceivable that they would vote for a change that would seriously weaken
their position.
Debentures
Debenture
A long-term bond that is not
secured by a mortgage on specific
property.
Subordinated Debentures
Subordinated Debentures
A bond having a claim on assets
only after the senior debt has been
paid off in the event of
liquidation.
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A debenture is an unsecured bond, and as such it provides no lien against specific property as security for the obligation. Debenture holders are, therefore,
general creditors whose claims are protected by property not otherwise
pledged. In practice, the use of debentures depends both on the nature of the
firm’s assets and on its general credit strength. Extremely strong companies
such as AT&T often use debentures; they simply do not need to put up property as security for their debt. Debentures are also issued by weak companies
that have already pledged most of their assets as collateral for mortgage loans.
In this latter case, the debentures are quite risky, and they will bear a high interest rate.
The term subordinate means “below,” or “inferior to,” and, in the event of bankruptcy, subordinated debt has claims on assets only after senior debt has been
paid off. Subordinated debentures may be subordinated either to designated
notes payable (usually bank loans) or to all other debt. In the event of liquida-
B O N D S A N D T H E I R VA L U AT I O N
S&P DEVELOPS CRITERIA TO DETERMINE BOND RATINGS FOR INTERNET FIRMS
D
etermining credit quality is always difficult, and this is particularly true for Internet firms. In a recent report, Standard
and Poor’s (S&P) highlighted some of the special challenges
these firms pose. First, many Internet firms are emphasizing
long-term growth as opposed to current profitability. While this
focus may be desirable for shareholders, the lack of profitability
creates additional risk for bondholders, which is a negative for
bond ratings. On the other hand, many Internet firms have
cash-rich balance sheets as a result of high IPO prices, and this
cash can be used as a cushion to pay bills and meet interest
payments.
S&P’s report outlines other factors on which it focuses when
evaluating Internet firms. Here is a partial list:
■
Brand recognition: Companies with well-established brand
names are more likely to survive, hence they receive
higher ratings.
■
■
■
Revenue diversity: Companies whose revenues are not tied
to a single idea or product generally have less risk and
better ratings.
Potential competition: S&P attempts to evaluate potential
entrants into the company’s line of business. Those with
loyal customers and fewer outside threats receive higher
ratings.
Long-run sustainability of the basic business model: This is
the most important factor, but the hardest to estimate.
SOURCE: “New Ratings Criteria for Internet Firms,” Standard & Poor’s CreditWeek,
June 23, 1999, 22–25.
tion or reorganization, holders of subordinated debentures cannot be paid until
all senior debt, as named in the debentures’ indenture, has been paid. Precisely
how subordination works, and how it strengthens the position of senior
debtholders, is explained in detail in Appendix 8B.
B O N D R AT I N G S
Investment Grade Bonds
Bonds rated triple-B or higher;
many banks and other
institutional investors are
permitted by law to hold only
investment grade bonds.
Junk Bond
A high-risk, high-yield bond.
Since the early 1900s, bonds have been assigned quality ratings that reflect
their probability of going into default. The three major rating agencies are
Moody’s Investors Service (Moody’s), Standard & Poor’s Corporation (S&P),
and Fitch Investors Service. Moody’s and S&P’s rating designations are
shown in Table 8-1.14 The triple- and double-A bonds are extremely safe.
Single-A and triple-B bonds are also strong enough to be called investment
grade bonds, and they are the lowest-rated bonds that many banks and
other institutional investors are permitted by law to hold. Double-B and
lower bonds are speculative, or junk bonds. These bonds have a significant
probability of going into default. A later section discusses junk bonds in
more detail.
14
In the discussion to follow, reference to the S&P rating is intended to imply the Moody’s and
Fitch’s ratings as well. Thus, triple-B bonds mean both BBB and Baa bonds; double-B bonds mean
both BB and Ba bonds; and so on.
D E F A U LT R I S K
375
TABLE
Moody’s and S&P Bond Ratings
8-1
INVESTMENT GRADE
JUNK BONDS
Moody’s
Aaa
Aa
A
Baa
Ba
B
Caa
C
S&P
AAA
AA
A
BBB
BB
B
CCC
D
NOTE: Both Moody’s and S&P use “modifiers” for bonds rated below triple-A. S&P uses a plus and minus
system; thus, A# designates the strongest A-rated bonds and A$ the weakest. Moody’s uses a 1, 2, or
3 designation, with 1 denoting the strongest and 3 the weakest; thus, within the double-A category,
Aa1 is the best, Aa2 is average, and Aa3 is the weakest.
Bond Rating Criteria
Bond ratings are based on both qualitative and quantitative factors, some of
which are listed below:
1. Various ratios, including the debt ratio and the times-interest-earned
ratio. The better the ratios, the higher the rating.
2. Mortgage provisions: Is the bond secured by a mortgage? If it is, and if
the property has a high value in relation to the amount of bonded debt,
the bond’s rating is enhanced.
3. Subordination provisions: Is the bond subordinated to other debt? If so,
it will be rated at least one notch below the rating it would have if it
were not subordinated. Conversely, a bond with other debt subordinated to it will have a somewhat higher rating.
4. Guarantee provisions: Some bonds are guaranteed by other firms. If a
weak company’s debt is guaranteed by a strong company (usually the weak
company’s parent), the bond will be given the strong company’s rating.
5. Sinking fund: Does the bond have a sinking fund to ensure systematic
repayment? This feature is a plus factor to the rating agencies.
6. Maturity: Other things the same, a bond with a shorter maturity will be
judged less risky than a longer-term bond, and this will be reflected in
the ratings.
7. Stability: Are the issuer’s sales and earnings stable?
8. Regulation: Is the issuer regulated, and could an adverse regulatory climate cause the company’s economic position to decline? Regulation is
especially important for utilities and telephone companies.
9. Antitrust: Are any antitrust actions pending against the firm that could
erode its position?
10. Overseas operations: What percentage of the firm’s sales, assets, and
profits are from overseas operations, and what is the political climate in
the host countries?
11. Environmental factors: Is the firm likely to face heavy expenditures for
pollution control equipment?
12. Product liability: Are the firm’s products safe? The tobacco companies
today are under pressure, and so are their bond ratings.
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13. Pension liabilities: Does the firm have unfunded pension liabilities that
could pose a future problem?
14. Labor unrest: Are there potential labor problems on the horizon that
could weaken the firm’s position? As this is written, a number of airlines
face this problem, and it has caused their ratings to be lowered.
15. Accounting policies: If a firm uses relatively conservative accounting
policies, its reported earnings will be of “higher quality” than if it uses
less conservative procedures. Thus, conservative accounting policies are
a plus factor in bond ratings.
Representatives of the rating agencies have consistently stated that no precise
formula is used to set a firm’s rating; all the factors listed, plus others, are taken
into account, but not in a mathematically precise manner. Statistical studies have
borne out this contention, for researchers who have tried to predict bond ratings
on the basis of quantitative data have had only limited success, indicating that the
agencies use subjective judgment when establishing a firm’s rating.15
Nevertheless, as we see in Table 8-2, there is a strong correlation between
bond ratings and many of the ratios that we described in Chapter 3. Not surprisingly, companies with lower debt ratios, higher free cash flow to debt, higher
returns on invested capital, higher EBITDA coverage ratios, and higher timesinterest-earned (TIE) ratios typically have higher bond ratings.
Importance of Bond Ratings
Bond ratings are important both to firms and to investors. First, because a
bond’s rating is an indicator of its default risk, the rating has a direct, measurable influence on the bond’s interest rate and the firm’s cost of debt. Second,
15
TABLE
8-2
See Ahmed Belkaoui, Industrial Bonds and the Rating Process (London: Quorum Books, 1983).
Bond Rating Criteria; Three-Year (1997–1999) Median Financial
Ratios for Different Bond Rating Classifications
Times-interest-earned (EBIT/Interest)
EBITDA interest coverage (EBITDA/Interest)
AAA
AA
17.5"
10.8"
21.8
14.6
A
6.8"
BBB
3.9"
BB
2.3"
B
1.0"
CCC
0.2"
9.6
6.1
3.8
55.8%
46.1%
30.5%
19.2%
55.4
24.6
15.6
6.6
1.9
Return on capital
28.2
22.9
19.9
14.0
11.7
7.2
0.5
Operating income/Salesa
29.2
21.3
18.3
15.3
15.4
11.2
13.6
Long-term debt/Total capital
15.2
26.4
32.5
41.0
55.8
70.7
80.3
Total debt/Total capital
26.9
35.6
40.1
47.4
61.3
74.6
89.4
Net cash flow/Total debt
105.8%
Free cash flow/Total debt
2.0
1.4
9.4%
5.8%
(4.5)
(14.0)
NOTE:
a
Operating income here is defined as sales minus cost of goods manufactured (before depreciation and amortization), selling, general and
administrative, and research and development costs.
SOURCE: “Adjusted Key U.S. Industrial Financial Ratios,” Standard & Poor’s CreditWeek, September 20, 2000, 39–44.
D E F A U LT R I S K
377
most bonds are purchased by institutional investors rather than individuals, and
many institutions are restricted to investment-grade securities. Thus, if a firm’s
bonds fall below BBB, it will have a difficult time selling new bonds because
many potential purchasers will not be allowed to buy them.
As a result of their higher risk and more restricted market, lower-grade bonds
have higher required rates of return, kd, than high-grade bonds. Figure 8-4 illustrates this point. In each of the years shown on the graph, U.S. government
bonds have had the lowest yields, AAAs have been next, and BBB bonds have
had the highest yields. The figure also shows that the gaps between yields on
the three types of bonds vary over time, indicating that the cost differentials,
or risk premiums, fluctuate from year to year. This point is highlighted in
Figure 8-5, which gives the yields on the three types of bonds and the risk
premiums for AAA and BBB bonds in June 1963 and September 2000.16 Note
first that the risk-free rate, or vertical axis intercept, rose 1.8 percentage points
from 1963 to 2000, primarily reflecting the increase in realized and anticipated
inflation. Second, the slope of the line has increased since 1963, indicating an
increase in investors’ risk aversion. Thus, the penalty for having a low credit
rating varies over time. Occasionally, as in 1963, the penalty is quite small, but
at other times it is large. These slope differences reflect investors’ aversion to
risk.
Changes in Ratings
Changes in a firm’s bond rating affect both its ability to borrow long-term capital and the cost of that capital. Rating agencies review outstanding bonds on a
periodic basis, occasionally upgrading or downgrading a bond as a result of its
issuer’s changed circumstances. For example, the September 13, 2000, issue of
Standard & Poor’s CreditWeek reported that Michaels Stores Inc.’s senior unsecured debt had been raised from BB$ to BB. Michaels is the leading retailer of
arts and crafts, and the rating upgrade reflects its improving performance measures and captial structure resulting from the redemption of $96.9 million convertible subordinated notes. The September 27, 2000, issue reported the downgrade of Loews Cineplex Entertainment Corp.’s bank loan and corporate credit
ratings from B to CCC#. This downgrade reflects the company’s weak operating performance, deteriorating credit measures, and an announcement that it
was in violation of certain financial covenants. The firm is in the process of negotiating with its bank group to resolve the covenant violation, and it is seeking additional capital to meet financing commitments.
16
The term risk premium ought to reflect only the difference in expected (and required) returns between two securities that results from differences in their risk. However, the differences between
yields to maturity on different types of bonds consist of (1) a true risk premium; (2) a liquidity premium, which reflects the fact that U.S. Treasury bonds are more readily marketable than most corporate bonds; (3) a call premium, because most Treasury bonds are not callable whereas corporate
bonds are; and (4) an expected loss differential, which reflects the probability of loss on the corporate bonds. As an example of the last point, suppose the yield to maturity on a BBB bond was 8.4 percent versus 5.8 percent on government bonds, but there was a 5 percent probability of total default
loss on the corporate bond. In this case, the expected return on the BBB bond would be 0.95(8.4%)
# 0.05(0%) ! 8.0%, and the risk premium would be 2.2 percent, not the full 2.6 percentage points
difference in “promised” yields to maturity. Because of all these points, the risk premiums given in
Figure 8-5 overstate somewhat the true (but unmeasurable) theoretical risk premiums.
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FIGURE
Yields on Selected Long-Term Bonds, 1960–2000
8-4
Percent
16
16
14
14
12
12
Corporate BBB
10
8
10
Corporate AAA
8
Wide Spread
Narrow Spread
6
6
U.S. Government
4
4
2
1960
2
1965
1970
1975
1980
1985
1990
1995
2000
SOURCES: Federal Reserve Board, Historical Chart Book, 1983, and Federal Reserve Bulletin, various issues.
D E F A U LT R I S K
379
FIGURE
Relationship between Bond Ratings and Bond Yields, 1963 and 2000
8-5
Rate of Return
(%)
2000
9.0
8.0
RPBBB = 2.6%
7.0
6.0
RPAAA = 1.8%
5.0
1963
RPBBB = 0.8%
4.0
RPAAA = 0.2%
U.S.
Treasury
Bonds
LONG-TERM
GOVERNMENT
BONDS
(DEFAULT-FREE)
(1)
AAA
BBB
Bond Ratings
RISK PREMIUMS
AAA CORPORATE
BONDS
(2)
BBB CORPORATE
BONDS
(3)
AAA
BBB
(4) ! (2) " (1)
(5) ! (3) " (1)
June 1963
4.0%
4.2%
4.8%
0.2%
0.8%
September 2000
5.8
7.6
8.4
1.8
2.6
RPAAA ! risk premium on AAA bonds.
RPBBB ! risk premium on BBB bonds.
SOURCES: Federal Reserve Bulletin, December 1963, and Federal Reserve Bank of St. Louis, Selected Interest Rates and U.S. Financial Data.
JUNK BONDS
Prior to the 1980s, fixed-income investors such as pension funds and insurance
companies were generally unwilling to buy risky bonds, so it was almost impossible for risky companies to raise capital in the public bond markets. Then, in
the late 1970s, Michael Milken of the investment banking firm Drexel Burnham
Lambert, relying on historical studies which showed that risky bonds yielded
more than enough to compensate for their risk, began to convince institutional
investors of the merits of purchasing risky debt. Thus was born the “junk bond,”
a high-risk, high-yield bond issued to finance a leveraged buyout, a merger, or
a troubled company.17 For example, Public Service of New Hampshire financed
17
Another type of junk bond is one that was highly rated when it was issued but whose rating has
fallen because the issuing corporation has fallen on hard times. Such bonds are called “fallen angels.”
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SANTA FE BONDS FINALLY MATURE AFTER 114 YEARS
I
n 1995, Santa Fe Pacific Company made the final payment on
some outstanding bonds that were originally issued in 1881!
While the bonds were paid off in full, their history has been
anything but routine.
Since the bonds were issued in 1881, investors have seen
Santa Fe go through two bankruptcy reorganizations, two depressions, several recessions, two world wars, and the collapse
of the gold standard. Through it all, the company remained intact, although ironically it did agree to be acquired by Burlington Northern just prior to the bonds’ maturity.
When the bonds were issued in 1881, they had a 6 percent
coupon. After a promising start, competition in the railroad
business, along with the Depression of 1893, dealt a crippling
one-two punch to the company’s fortunes. After two bankruptcy
reorganizations — and two new management teams — the company got back on its feet, and in 1895 it replaced the original
bonds with new 100-year bonds. The new bonds, sanctioned by
the Bankruptcy Court, matured in 1995 and carried a 4 percent
coupon. However, they also had a wrinkle that was in effect
until 1900 — the company could skip the coupon payment if, in
management’s opinion, earnings were not sufficiently high to
service the debt. After 1900, the company could no longer just
ignore the coupon, but it did have the option of deferring the
payments if management deemed deferral necessary. In the late
1890s, Santa Fe did skip the interest, and the bonds sold at an
all-time low of $285 (28.5% of par) in 1896. The bonds reached
a peak in 1946, when they sold for $1,312.50 in the strong, low
interest rate economy after World War II.
Interestingly, the bonds’ principal payment was originally
pegged to the price of gold, meaning that the principal received at maturity would increase if the price of gold increased.
This type of contract was declared invalid in 1933 by President
Roosevelt and Congress, and the decision was upheld by the
Supreme Court in a 5–4 vote. If just one Supreme Court justice
had gone the other way, then, due to an increase in the price
of gold, the bonds would have been worth $18,626 rather than
$1,000 when they matured in 1995!
In many ways, the saga of the Santa Fe bonds is a testament
to the stability of the U.S. financial system. On the other hand,
it illustrates the many types of risks that investors face when
they purchase long-term bonds. Investors in the 100-year
bonds issued by Disney and Coca-Cola, among others, should
perhaps take note.
construction of its troubled Seabrook nuclear plant with junk bonds, and junk
bonds were used by Ted Turner to finance the development of CNN and
Turner Broadcasting. In junk bond deals, the debt ratio is generally extremely
high, so the bondholders must bear as much risk as stockholders normally
would. The bonds’ yields reflect this fact — a promised return of 25 percent per
annum was required to sell the Public Service of New Hampshire bonds.
The emergence of junk bonds as an important type of debt is another example
of how the investment banking industry adjusts to and facilitates new developments in capital markets. In the 1980s, mergers and takeovers increased dramatically. People like T. Boone Pickens and Henry Kravis thought that certain oldline, established companies were run inefficiently and were financed too
conservatively, and they wanted to take these companies over and restructure
them. Michael Milken and his staff at Drexel Burnham Lambert began an active
campaign to persuade certain institutions (often S&Ls) to purchase high-yield
bonds. Milken developed expertise in putting together deals that were attractive
to the institutions yet feasible in the sense that projected cash flows were sufficient to meet the required interest payments. The fact that interest on the bonds
was tax deductible, combined with the much higher debt ratios of the restructured firms, also increased after-tax cash flows and helped make the deals feasible.
The development of junk bond financing has done much to reshape the U.S.
financial scene. The existence of these securities contributed to the loss of independence of Gulf Oil and hundreds of other companies, and it led to major
shake-ups in such companies as CBS, Union Carbide, and USX (formerly U.S.
D E F A U LT R I S K
381
Steel). It also caused Drexel Burnham Lambert to leap from essentially
nowhere in the 1970s to become the most profitable investment banking firm
during the 1980s.
The phenomenal growth of the junk bond market was impressive, but controversial. In 1989, Drexel Burnham Lambert was forced into bankruptcy, and
“junk bond king” Michael Milken, who had earned $500 million two years earlier, was sent to jail. Those events led to the collapse of the junk bond market
in the early 1990s. Since then, however, the junk bond market has rebounded,
and junk bonds are here to stay as an important form of corporate financing.
BANKRUPTCY
AND
R E O R G A N I Z AT I O N
During recessions, bankruptcies normally rise, and the most recent recession
(in 1991–1992) was no exception. The 1991–1992 casualties included Pan Am,
Carter Hawley Hale Stores, Continental Airlines, R. H. Macy & Company,
Zale Corporation, and McCrory Corporation. Because of its importance, at
least a brief discussion of bankruptcy is warranted within the chapter, and a
more detailed discussion is presented in Appendix 8B.
When a business becomes insolvent, it does not have enough cash to meet
its interest and principal payments. A decision must then be made whether to
dissolve the firm through liquidation or to permit it to reorganize and thus stay
alive. These issues are addressed in Chapters 7 and 11 of the federal bankruptcy statutes, and the final decision is made by a federal bankruptcy court
judge.
The decision to force a firm to liquidate versus permit it to reorganize depends on whether the value of the reorganized firm is likely to be greater than
the value of the firm’s assets if they are sold off piecemeal. In a reorganization,
the firm’s creditors negotiate with management on the terms of a potential reorganization. The reorganization plan may call for a restructuring of the firm’s
debt, in which case the interest rate may be reduced, the term to maturity
lengthened, or some of the debt may be exchanged for equity. The point of the
restructuring is to reduce the financial charges to a level that the firm’s cash
flows can support. Of course, the common stockholders also have to give up
something — they often see their position diluted as a result of additional
shares being given to debtholders in exchange for accepting a reduced amount
of debt principal and interest. A trustee may be appointed by the court to oversee the reorganization, but generally the existing management is allowed to retain control.
Liquidation occurs if the company is deemed to be too far gone to be saved
— if it is worth more dead than alive. If the bankruptcy court orders a liquidation, assets are sold off and the cash obtained is distributed as specified in
Chapter 7 of the Bankruptcy Act. Here is the priority of claims:
1. Secured creditors are entitled to the proceeds from the sale of the specific property that was used to support their loans.
2. The trustee’s costs of administering and operating the bankrupt firm are
next in line.
3. Expenses incurred after bankruptcy was filed come next.
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4. Wages due workers, up to a limit of $2,000 per worker, follow.
5. Claims for unpaid contributions to employee benefit plans are next.
This amount, together with wages, cannot exceed $2,000 per worker.
6. Unsecured claims for customer deposits up to $900 per customer are
sixth in line.
7. Federal, state, and local taxes due come next.
8. Unfunded pension plan liabilities are next. (Limitations exist as specified
in Appendix 8B.)
9. General unsecured creditors are ninth on the list.
10. Preferred stockholders come next, up to the par value of their stock.
11. Common stockholders are finally paid, if anything is left, which is rare.
Appendix 8B provides an illustration of how a firm’s assets are distributed
after it has been liquidated. For now, you should know (1) that the federal
bankruptcy statutes govern both reorganization and liquidation, (2) that bankruptcies occur frequently, and (3) that a priority of the specified claims must be
followed when distributing the assets of a liquidated firm.
SELF-TEST QUESTIONS
Differentiate between mortgage bonds and debentures.
Name the major rating agencies, and list some factors that affect bond ratings.
Why are bond ratings important both to firms and to investors?
For what purposes have junk bonds typically been used?
Differentiate between a Chapter 7 liquidation and a Chapter 11 reorganization. When would each be used?
List the priority of claims for the distribution of a liquidated firm’s assets.
BOND MARKETS
Corporate bonds are traded primarily in the over-the-counter market. Most
bonds are owned by and traded among the large financial institutions (for example, life insurance companies, mutual funds, and pension funds, all of which
deal in very large blocks of securities), and it is relatively easy for the over-thecounter bond dealers to arrange the transfer of large blocks of bonds among the
relatively few holders of the bonds. It would be much more difficult to conduct
similar operations in the stock market among the literally millions of large and
small stockholders, so a higher percentage of stock trades occur on the exchanges.
Information on bond trades in the over-the-counter market is not published,
but a representative group of bonds is listed and traded on the bond division of
BOND MARKETS
383
FIGURE
8-6
NYSE Bond Market Transactions, October 10, 2000
C O R P O R AT I O N B O N D S
VOLUME $8,119,000
BONDS
BellsoT 61⁄ 403
3
CUR YLD
VOL
CLOSE
NET CHG.
6.4
10
983⁄ 8
$3⁄ 8
3
BellsoT 6 ⁄ 804
6.5
25
98 ⁄ 4
#3⁄ 4
BellsoT 57⁄ 809
6.5
20
905⁄ 8
$1⁄ 2
BellsoT 7s25
7.5
50
BellsoT 81⁄ 432
8.2
20
101
$1⁄ 2
. . .
8.1
30
93
#7⁄ 8
1
BellsoT 7 ⁄ 233
1
93 ⁄ 4
SOURCE: The Wall Street Journal, October 11, 2000, C13.
the NYSE. Figure 8-6 gives a section of the bond market page of The Wall
Street Journal for trading on October 10, 2000. A total of 146 issues were traded
on that date, but we show only the bonds of BellSouth Telecommunications.
Note that BellSouth Telecommunications had six different bonds that were
traded on October 10. The company actually had more than 10 bond issues
outstanding, but several of them did not trade on that date.
The bonds of BellSouth and other companies can have various denominations, but for convenience we generally think of each bond as having a par
value of $1,000 — this is how much per bond the company borrowed and how
much it must someday repay. However, since other denominations are possible, for trading and reporting purposes bonds are quoted as percentages of
par. Looking at the fourth bond listed in the data in Figure 8-6, we see that
there is a 7 just after the company’s name; this indicates that the bond is of
the series that pays 7 percent interest, or 0.07($1,000) ! $70.00 of interest
per year. The 7 percent is the bond’s coupon rate. The BellSouth Telecommunications bonds, and all the others listed in the Journal, pay interest semiannually, so all rates are nominal, not EAR rates. The 25 which comes next indicates that this bond matures and must be repaid in the year 2025; it is not
shown in the figure, but this bond was issued in 1995, so it had a 30-year
original maturity. The 7.5 in the second column is the bond’s current yield:
Current yield ! $70.00/$932.50 ! 7.51%, rounded to 7.5 percent. The 50 in
the third column indicates that 50 of these bonds were traded on October 10,
2000. Since the price shown in the fourth column is expressed as a percentage
of par, the bond closed at 93.25 percent, which translates to $932.50, down
0.5 percent from the previous close.
Coupon rates are generally set at levels that reflect the “going rate of interest” on the day a bond is issued. If the rates were set lower, investors simply
would not buy the bonds at the $1,000 par value, so the company could not
borrow the money it needed. Thus, bonds generally sell at their par values on
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FIGURE
BellSouth Telecommunications 7%, 30-Year Bond: Market Value
as Interest Rates Change
8-7
Bond Value
($)
1,200
Actual Price of the
7% Coupon Bond
1,100
1,000
900
0
1995
Bond’s Projected Price
if Interest Rates Remain
Constant from 2000 to 2025
2000
2005
2010
2015
2020
2025
Years
NOTE: The line from 2000 to 2025 appears linear, but it actually has a slight upward curve.
the day they are issued, but their prices fluctuate thereafter as interest rates
change.
As shown in Figure 8-7, the BellSouth Telecommunications bonds initially
sold at par. The bonds rose above par in 1995 when interest rates dipped below
7 percent, but then fell below par in 1996 when interest rates rose. Over the
next four years this pattern was repeated: The price rose above par in 1997 and
1998 when interest rates fell, but the price fell again in 1999 and 2000 after another increase in interest rates. The dashed line in Figure 8-7 shows the projected price of the bonds, in the unlikely event that interest rates remain constant from 2000 to 2025. Looking at the actual and projected price history of
these bonds, we see (1) the inverse relationship between interest rates and bond
values and (2) the fact that bond values approach their par values as their maturiy date approaches.
SELF-TEST QUESTIONS
Why do most bond trades occur in the over-the-counter market?
If a bond issue is to be sold at par, how will its coupon rate be determined?
BOND MARKETS
385
This chapter described the different types of bonds governments and corporations issue, explained how bond prices are established, and discussed how investors estimate the rates of return they can expect to earn. We also discussed
the various types of risks that investors face when they buy bonds.
It is important to remember that when an investor purchases a company’s
bonds, that investor is providing the company with capital. Therefore, when a
firm issues bonds, the return that investors receive represents the cost of debt financing for the issuing company. This point is emphasized in Chapter 10, where the
ideas developed in this chapter are used to help determine a company’s overall
cost of capital, which is a basic component in the capital budgeting process.
The key concepts covered in this chapter are listed below:
■
■
■
■
■
■
A bond is a long-term promissory note issued by a business or governmental unit. The issuer receives money in exchange for promising to make interest payments and to repay the principal on a specified future date.
Some recent innovations in long-term financing include zero coupon
bonds, which pay no annual interest but which are issued at a discount;
floating rate debt, whose interest payments fluctuate with changes in the
general level of interest rates; and junk bonds, which are high-risk, highyield instruments issued by firms with very high debt ratios.
A call provision gives the issuing corporation the right to redeem the
bonds prior to maturity under specified terms, usually at a price greater
than the maturity value (the difference is a call premium). A firm will typically call a bond if interest rates fall substantially below the coupon rate.
A sinking fund is a provision that requires the corporation to retire a portion of the bond issue each year. The purpose of the sinking fund is to
provide for the orderly retirement of the issue. A sinking fund typically requires no call premium.
The value of a bond is found as the present value of an annuity (the interest payments) plus the present value of a lump sum (the principal). The
bond is evaluated at the appropriate periodic interest rate over the number of periods for which interest payments are made.
The equation used to find the value of an annual coupon bond is:
N
INT
M
VB ! a
.
t #
(1 # k d )N
t!1 (1 # k d )
■
386
CHAPTER 8
■
An adjustment to the formula must be made if the bond pays interest
semiannually: divide INT and kd by 2, and multiply N by 2.
The return earned on a bond held to maturity is defined as the bond’s
yield to maturity (YTM). If the bond can be redeemed before maturity,
it is callable, and the return investors receive if it is called is defined as the
yield to call (YTC). The YTC is found as the present value of the interest payments received while the bond is outstanding plus the present value
of the call price (the par value plus a call premium).
B O N D S A N D T H E I R VA L U AT I O N
8-7
c. A change in the bankruptcy code makes it more difficult for bondholders to receive
payments in the event a firm declares bankruptcy.
d. The economy enters a recession.
e. The bonds become subordinated to another debt issue.
Assume that you have a short investment horizon (that is, less than one year). You are
considering two investments: a 1-year Treasury security and a 20-year Treasury security.
Which of the two investments would you view as being more risky?
SELF-TEST PROBLEMS
ST-1
Key terms
ST-2
Bond valuation
ST-3
Sinking fund
388
CHAPTER 8
■
(SOLUTIONS APPEAR IN APPENDIX B)
Define each of the following terms:
a. Bond; Treasury bond; corporate bond; municipal bond; foreign bond
b. Par value; maturity date; original maturity
c. Coupon payment; coupon interest rate
d. Floating rate bond
e. Premium bond; discount bond
f. Current yield (on a bond); yield to maturity (YTM); yield to call (YTC)
g. Reinvestment rate risk; interest rate risk; investment horizon
h. Default risk
i. Mortgage bond
j. Debenture; subordinated debenture
k. Convertible bond; warrant; income bond; indexed, or purchasing power, bond
l. Call provision; sinking fund provision; indenture
m. Zero coupon bond; original issue discount (OID) bond
n. Junk bond; investment grade bonds
The Pennington Corporation issued a new series of bonds on January 1, 1978. The
bonds were sold at par ($1,000), have a 12 percent coupon, and mature in 30 years, on
December 31, 2007. Coupon payments are made semiannually (on June 30 and December 31).
a. What was the YTM of Pennington’s bonds on January 1, 1978?
b. What was the price of the bond on January 1, 1983, 5 years later, assuming that the
level of interest rates had fallen to 10 percent?
c. Find the current yield and capital gains yield on the bond on January 1, 1983, given
the price as determined in part b.
d. On July 1, 2001, Pennington’s bonds sold for $916.42. What was the YTM at that
date?
e. What were the current yield and capital gains yield on July 1, 2001?
f. Now, assume that you purchased an outstanding Pennington bond on March 1, 2001,
when the going rate of interest was 15.5 percent. How large a check must you have
written to complete the transaction? This is a hard question! (Hint: PVIFA7.75%,13 !
8.0136 and PVIF7.75%,13 ! 0.3789.)
The Vancouver Development Company has just sold a $100 million, 10-year, 12 percent
bond issue. A sinking fund will retire the issue over its life. Sinking fund payments are
of equal amounts and will be made semiannually, and the proceeds will be used to retire
bonds as the payments are made. Bonds can be called at par for sinking fund purposes,
or the funds paid into the sinking fund can be used to buy bonds in the open market.
a. How large must each semiannual sinking fund payment be?
b. What will happen, under the conditions of the problem thus far, to the company’s
debt service requirements per year for this issue over time?
c. Now suppose Vancouver Development set up its sinking fund so that equal annual
amounts, payable at the end of each year, are paid into a sinking fund trust held by a
bank, with the proceeds being used to buy government bonds that pay 9 percent interest. The payments, plus accumulated interest, must total $100 million at the end
of 10 years, and the proceeds will be used to retire the bonds at that time. How large
must the annual sinking fund payment be now?
d. What are the annual cash requirements for covering bond service costs under the
trusteeship arrangement described in part c? (Note: Interest must be paid on Vancouver’s outstanding bonds but not on bonds that have been retired.)
e. What would have to happen to interest rates to cause the company to buy bonds on
the open market rather than call them under the original sinking fund plan?
B O N D S A N D T H E I R VA L U AT I O N
S TA R T E R P R O B L E M S
8-1
Bond valuation
8-2
Financial calculator needed;
Yield to maturity
8-3
Financial calculator needed;
Yield to maturity and call
8-4
Current yield
8-5
Financial calculator needed;
Bond valuation
8-6
Financial calculator needed;
Current yield and yield to maturity
Callaghan Motors’ bonds have 10 years remaining to maturity. Interest is paid annually,
the bonds have a $1,000 par value, and the coupon interest rate is 8 percent. The bonds
have a yield to maturity of 9 percent. What is the current market price of these bonds?
Wilson Wonders’ bonds have 12 years remaining to maturity. Interest is paid annually,
the bonds have a $1,000 par value, and the coupon interest rate is 10 percent. The bonds
sell at a price of $850. What is their yield to maturity?
Thatcher Corporation’s bonds will mature in 10 years. The bonds have a face value of
$1,000 and an 8 percent coupon rate, paid semiannually. The price of the bonds is
$1,100. The bonds are callable in 5 years at a call price of $1,050. What is the yield to
maturity? What is the yield to call?
Heath Foods’ bonds have 7 years remaining to maturity. The bonds have a face value of
$1,000 and a yield to maturity of 8 percent. They pay interest annually and have a 9 percent coupon rate. What is their current yield?
Nungesser Corporation has issued bonds that have a 9 percent coupon rate, payable
semiannually. The bonds mature in 8 years, have a face value of $1,000, and a yield to
maturity of 8.5 percent. What is the price of the bonds?
A bond that matures in 10 years sells for $985. The bond has a face value of $1,000 and
a 7 percent annual coupon.
a. What is the bond’s current yield?
b. What is the bond’s yield to maturity (YTM)?
c. Assume that the yield to maturity remains constant for the next 3 years. What will be
the price of the bond 3 years from today?
EXAM-TYPE PROBLEMS
8-7
Bond valuation
8-8
Yield to maturity
8-9
Yield to call
8-10
Financial calculator needed;
Bond yields
8-11
Financial calculator needed;
Current yield and yield to maturity
The problems included in this section are set up in such a way that they could be converted to
multiple-choice exam problems.
The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual
interest plus $1,000 at maturity. Bond L has a maturity of 15 years, and Bond S a maturity of 1 year.
a. What will be the value of each of these bonds when the going rate of interest is (1)
5 percent, (2) 8 percent, and (3) 12 percent? Assume that there is only one more interest payment to be made on Bond S.
b. Why does the longer-term (15-year) bond fluctuate more when interest rates change
than does the shorter-term bond (1-year)?
The Heymann Company’s bonds have 4 years remaining to maturity. Interest is paid annually; the bonds have a $1,000 par value; and the coupon interest rate is 9 percent.
a. What is the yield to maturity at a current market price of (1) $829 or (2) $1,104?
b. Would you pay $829 for one of these bonds if you thought that the appropriate rate
of interest was 12 percent — that is, if kd ! 12%? Explain your answer.
Six years ago, The Singleton Company sold a 20-year bond issue with a 14 percent annual coupon rate and a 9 percent call premium. Today, Singleton called the bonds. The
bonds originally were sold at their face value of $1,000. Compute the realized rate of return for investors who purchased the bonds when they were issued and who surrender
them today in exchange for the call price.
A 10-year, 12 percent semiannual coupon bond, with a par value of $1,000, may be
called in 4 years at a call price of $1,060. The bond sells for $1,100. (Assume that the
bond has just been issued.)
a. What is the bond’s yield to maturity?
b. What is the bond’s current yield?
c. What is the bond’s capital gain or loss yield?
d. What is the bond’s yield to call?
A bond that matures in 6 years has an 8 percent coupon rate, semiannual payments, a
face value of $1,000, and a 7.7 percent current yield. What is the bond’s nominal yield
to maturity (YTM)?
EXAM-TYPE PROBLEMS
389
8-12
Financial calculator needed;
Yield to maturity
8-13
Financial calculator needed;
Current yield
8-14
Nominal interest rate
You just purchased a bond that matures in 5 years. The bond has a face value of $1,000,
an 8 percent annual coupon, and has a current yield of 8.21 percent. What is the bond’s
yield to maturity (YTM)?
A bond that matures in 7 years sells for $1,020. The bond has a face value of $1,000 and
a yield to maturity of 10.5883 percent. The bond pays coupons semiannually. What is
the bond’s current yield?
Lloyd Corporation’s 14 percent coupon rate, semiannual payment, $1,000 par value
bonds, which mature in 30 years, are callable 5 years from now at a price of $1,050. The
bonds sell at a price of $1,353.54, and the yield curve is flat. Assuming that interest rates
in the economy are expected to remain at their current level, what is the best estimate
of Lloyd’s nominal interest rate on new bonds?
PROBLEMS
8-15
Bond valuation
8-16
Bond reporting
8-17
Discount bond valuation
8-18
Yield to call
390
CHAPTER 8
■
Suppose Ford Motor Company sold an issue of bonds with a 10-year maturity, a $1,000
par value, a 10 percent coupon rate, and semiannual interest payments.
a. Two years after the bonds were issued, the going rate of interest on bonds such as
these fell to 6 percent. At what price would the bonds sell?
b. Suppose that, 2 years after the initial offering, the going interest rate had risen to 12
percent. At what price would the bonds sell?
c. Suppose that the conditions in part a existed — that is, interest rates fell to 6 percent
2 years after the issue date. Suppose further that the interest rate remained at 6 percent for the next 8 years. What would happen to the price of the Ford Motor Company bonds over time?
Look up the prices of American Telephone & Telegraph’s (AT&T) bonds in The Wall
Street Journal (or some other newspaper that provides this information).
a. If AT&T were to sell a new issue of $1,000 par value long-term bonds, approximately
what coupon interest rate would it have to set on the bonds if it wanted to bring
them out at par?
b. If you had $10,000 and wanted to invest it in AT&T, what return would you expect
to get if you bought AT&T’s bonds?
Assume that in February 1970 the Los Angeles Airport Authority issued a series of 3.4
percent, 30-year bonds. Interest rates rose substantially in the years following the issue,
and as they did, the price of the bonds declined. Also, assume in February 1983, 13 years
later, the price of the bonds had dropped from $1,000 to $650. In answering the following questions, assume that the bond requires annual interest payments.
a. Each bond originally sold at its $1,000 par value. What was the yield to maturity of
these bonds when they were issued?
b. Calculate the yield to maturity in February 1983.
c. Assume that interest rates stabilized at the 1983 level and stayed there for the remainder of the life of the bonds. What would have been the bonds’ price in February 1998, when they had 2 years remaining to maturity?
d. What was the price of the bonds the day before they matured in 2000? (Disregard
the last interest payment.)
e. In 1983, the Los Angeles Airport bonds were classified as “discount bonds.” What
happens to the price of a discount bond as it approaches maturity? Is there a “builtin capital gain” on such bonds?
f. The coupon interest payment divided by the market price of a bond is called the
bond’s current yield. Assuming the conditions in part c, what would have been the current yield of a Los Angeles Airport bond (1) in February 1983 and (2) in February
1998? What would have been its capital gains yields and total yields (total yield
equals yield to maturity) on those same two dates?
It is now January 1, 2002, and you are considering the purchase of an outstanding
Racette Corporation bond that was issued on January 1, 2000. The Racette bond has a
9.5 percent annual coupon and a 30-year original maturity (it matures on December 31,
2029). There is a 5-year call protection (until December 31, 2004), after which time the
bond can be called at 109 (that is, at 109 percent of par, or $1,090). Interest rates have
declined since the bond was issued, and the bond is now selling at 116.575 percent of
B O N D S A N D T H E I R VA L U AT I O N
8-19
Financial calculator needed;
Interest rate sensitivity
8-20
Financial calculator needed;
Bond valuation
par, or $1,165.75. You want to determine both the yield to maturity and the yield to call
for this bond. (Note: The yield to call considers the effect of a call provision on the
bond’s probable yield. In the calculation, we assume that the bond will be outstanding
until the call date, at which time it will be called. Thus, the investor will have received
interest payments for the call-protected period and then will receive the call price — in
this case, $1,090 — on the call date.)
a. What is the yield to maturity in 2002 for the Racette bond? What is its yield to call?
b. If you bought this bond, which return do you think you would actually earn? Explain
your reasoning.
c. Suppose the bond had sold at a discount. Would the yield to maturity or the yield to
call have been more relevant?
A bond trader purchased each of the following bonds at a yield to maturity of 8 percent.
Immediately after she purchased the bonds interest rates fell to 7 percent. What is the
percentage change in the price of each bond after the decline in interest rates? Fill in the
following table:
PRICE @ 8%
PRICE @ 7%
PERCENTAGE CHANGE
10-year, 10% annual coupon
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
10-year zero
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
5-year zero
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
30-year zero
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
$100 perpetuity
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face
value of $1,000, and has a yield to maturity equal to 9.6 percent. One bond, Bond C,
pays an annual coupon of 10 percent; the other bond, Bond Z, is a zero coupon bond.
a. Assuming that the yield to maturity of each bond remains at 9.6 percent over the next
4 years, what will be the price of each of the bonds at the following time periods? Fill
in the following table:
t
PRICE OF BOND C
PRICE OF BOND Z
0
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
1
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
2
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
3
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
4
!!!!!!!!!!!!!!!!!!!!!
!!!!!!!!!!!!!!!!!!!!!
b. Plot the time path of the prices for each of the two bonds.
SPREADSHEET PROBLEM
8-21
Bond valuation
Rework Problem 8-10 using a spreadsheet model. After completing parts a through d,
answer the following related questions.
e. How would the price of the bond be affected by changing interest rates? (Hint: Conduct a sensitivity analysis of price to changes in the yield to maturity, which is also
the going market interest rate for the bond. Assume that the bond will be called if
and only if the going rate of interest falls below the coupon rate. That is an oversimplification, but assume it anyway for purposes of this problem.)
f. Now assume that the date is 10/25/2001. Assume further that our 12 percent, 10year bond was issued on 7/1/2001, is callable on 7/1/2005 at $1,060, will mature on
6/30/2011, pays interest semiannually (January 1 and July 1), and sells for $1,100.
Use your spreadsheet to find (1) the bond’s yield to maturity and (2) its yield to
call.
SPREADSHEET PROBLEM
391
8-22
Bonds and their valuation
392
CHAPTER 8
■
The information related to the cyberproblems is likely to change over time, due to the
release of new information and the ever-changing nature of the World Wide Web. With
these changes in mind, we will periodically update these problems on the textbook’s web
site. To avoid problems, please check for these updates before proceeding with the cyberproblems.
All bonds have some common characteristics, but they do not always have the
same contractual features. Differences in contractual provisions, and in the underlying strength of the companies backing the bonds, lead to major differences in
bonds’ risks, prices, and expected returns. The risk investors are exposed to when
buying a bond is in part gauged by bond rating agencies. The three major bond
rating agencies are Moody’s, Standard & Poor’s, and Fitch’s. Bonds are assigned
quality ratings that reflect their probability of default. Changes in a firm’s bond
rating influence its ability to borrow long-term capital and the cost of that capital.
Rating agencies review outstanding bonds on a periodic basis, occasionally upgrading or downgrading a bond because of changes in an issuer’s circumstances. Visit
http://www.standardandpoors.com/ResourceCenter and answer the following
questions:
a. On what information are corporate issuer credit ratings based? To answer this
question, click on “Ratings Definitions.”
b. What do the following long-term issuer credit ratings mean: AAA, AA, A, BBB,
CCC, and D?
c. Some debt issues have a plus (#) or minus ($) after their letter rating. What does
the plus (#) or ($) signify?
d. How does Standard & Poor’s assign ratings to short-term debt issues? Compare
the A-1, A-2, A-3, B, and C ratings to each other.
e. What is CreditWatch?
f. For what other types of issues does Standard & Poor’s offer ratings services?
B O N D S A N D T H E I R VA L U AT I O N
WESTERN MONEY MANAGEMENT INC.
8-23 Bond Valuation Robert Black and Carol Alvarez are
vice-presidents of Western Money Management and codirectors of the company’s pension fund management division.
A major new client, the California League of Cities, has requested that Western present an investment seminar to the
mayors of the represented cities, and Black and Alvarez, who
will make the actual presentation, have asked you to help
them by answering the following questions.
a. What are the key features of a bond?
b. What are call provisions and sinking fund provisions?
Do these provisions make bonds more or less risky?
c. How is the value of any asset whose value is based on expected future cash flows determined?
d. How is the value of a bond determined? What is the value
of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent?
e. (1) What would be the value of the bond described in
part d if, just after it had been issued, the expected
inflation rate rose by 3 percentage points, causing investors to require a 13 percent return? Would we
now have a discount or a premium bond? (If you do
not have a financial calculator, PVIF13%,10 ! 0.2946;
PVIFA13%,10 ! 5.4262.)
(2) What would happen to the bond’s value if inflation
fell, and kd declined to 7 percent? Would we now
have a premium or a discount bond?
(3) What would happen to the value of the 10-year bond
over time if the required rate of return remained at
13 percent, or if it remained at 7 percent? (Hint:
With a financial calculator, enter PMT, I, FV, and N,
and then change (override) N to see what happens to
the PV as the bond approaches maturity.)
f. (1) What is the yield to maturity on a 10-year, 9 percent, annual coupon, $1,000 par value bond that sells
for $887.00? That sells for $1,134.20? What does
the fact that a bond sells at a discount or at a premium tell you about the relationship between kd and
the bond’s coupon rate?
g.
h.
i.
j.
k.
l.
m.
n.
o.
(2) What are the total return, the current yield, and the
capital gains yield for the discount bond? (Assume
the bond is held to maturity and the company does
not default on the bond.)
What is interest rate (or price) risk? Which bond has more
interest rate risk, an annual payment 1-year bond or a
10-year bond? Why?
What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond?
How does the equation for valuing a bond change if
semiannual payments are made? Find the value of a 10year, semiannual payment, 10 percent coupon bond if
nominal kd ! 13%. (Hint: PVIF6.5%,20 ! 0.2838 and
PVIFA6.5%,20 ! 11.0185.)
Suppose you could buy, for $1,000, either a 10 percent,
10-year, annual payment bond or a 10 percent, 10-year,
semiannual payment bond. They are equally risky.
Which would you prefer? If $1,000 is the proper price
for the semiannual bond, what is the equilibrium price
for the annual payment bond?
Suppose a 10-year, 10 percent, semiannual coupon bond
with a par value of $1,000 is currently selling for
$1,135.90, producing a nominal yield to maturity of 8
percent. However, the bond can be called after 4 years
for a price of $1,050.
(1) What is the bond’s nominal yield to call (YTC)?
(2) If you bought this bond, do you think you would be
more likely to earn the YTM or the YTC? Why?
Does the yield to maturity represent the promised or expected return on the bond?
These bonds were rated AA$ by S&P. Would you consider these bonds investment grade or junk bonds?
What factors determine a company’s bond rating?
If this firm were to default on the bonds, would the
company be immediately liquidated? Would the bondholders be assured of receiving all of their promised
payments?
I N T E G R AT E D C A S E
393
8A
ZERO COUPON BONDS
To understand how zeros are used and analyzed, consider the zeros that are
going to be issued by Vandenberg Corporation, a shopping center developer.
Vandenberg is developing a new shopping center in San Diego, California, and
it needs $50 million. The company does not anticipate major cash flows from
the project for about five years. However, Pieter Vandenberg, the president,
plans to sell the center once it is fully developed and rented, which should take
about five years. Therefore, Vandenberg wants to use a financing vehicle that
will not require cash outflows for five years, and he has decided on a five-year
zero coupon bond, with a maturity value of $1,000.
Vandenberg Corporation is an A-rated company, and A-rated zeros with
five-year maturities yield 6 percent at this time (five-year coupon bonds also
yield 6 percent). The company is in the 40 percent federal-plus-state tax
bracket. Pieter Vandenberg wants to know the firm’s after-tax cost of debt if it
uses 6 percent, five-year maturity zeros, and he also wants to know what the
bond’s cash flows will be. Table 8A-1 provides an analysis of the situation, and
the following numbered paragraphs explain the table itself.
TABLE
Analysis of a Zero Coupon Bond from Issuer’s Perspective
8A-1
BASIC DATA
Maturity value
$1,000
kd
6.00%, annual compounding
Maturity
5 years
Corporate tax rate
40.00%
Issue price
$747.26
ANALYSIS
0
(1) Year-end accrued value
$747.26
1
2
3
4
$792.10
$839.62
$890.00
$943.40
$1,000.00
44.84
47.52
50.38
53.40
56.60
6%
(2) Interest deduction
(3) Tax savings (40%)
(4) Cash flow to Vandenberg
#747.26
After-tax cost of debt
17.94
19.01
20.15
21.36
22.64
#17.94
#19.01
#20.15
#21.36
$977.36
3.60%
Face value of bonds the company must issue to raise $50 million ! Amount needed/Issue price as % of par
! $50,000,000/ 0.74726
! $66,911,000.
394
APPENDIX 8A
■
5 Years
ZERO COUPON BONDS
1. The information in the “Basic Data” section, except the issue price, was
given in the preceding paragraph, and the information in the “Analysis”
section was calculated using the known data. The maturity value of the
bond is always set at $1,000 or some multiple thereof.
2. The issue price is the PV of $1,000, discounted back five years at the rate
kd ! 6%, annual compounding. Using the tables, we find PV !
$1,000(0.7473) ! $747.30. Using a financial calculator, we input N ! 5,
I ! 6, PMT ! 0, and FV ! 1000, then press the PV key to find PV !
$747.26. Note that $747.26, compounded annually for five years at 6 percent, will grow to $1,000 as shown by the time line on Line 1 in Table
8A-1.
3. The accrued values as shown on Line 1 in the analysis section represent
the compounded value of the bond at the end of each year. The accrued
value for Year 0 is the issue price; the accrued value for Year 1 is found as
$747.26(1.06) ! $792.10; the accrued value at the end of Year 2 is
$747.26(1.06)2 ! $839.62; and, in general, the value at the end of any
Year n is
Accrued value at the end of Year n ! Issue price " (1 # kd)n.
(8A-1)
4. The interest deduction as shown on Line 2 represents the increase in accrued value during the year. Thus, interest in Year 1 ! $792.10 $
$747.26 ! $44.84. In general,
Interest in Year n ! Accrued valuen $ Accrued valuen$1.
(8A-2)
This method of calculating taxable interest is specified in the Tax Code.
5. The company can deduct interest each year, even though the payment is
not made in cash. This deduction lowers the taxes that would otherwise
be paid, producing the following tax savings:
Tax savings ! (Interest deduction)(T).
(8A-3)
! $44.84(0.4)
! $17.94 in Year 1.
6. Line 4 represents cash flows on a time line; it shows the cash flow at the
end of Years 0 through 5. At Year 0, the company receives the $747.26
issue price. The company also has positive cash inflows equal to the tax
savings during Years 1 through 4. Finally, in Year 5, it must pay the
$1,000 maturity value, but it gets one more year of interest tax savings.
Therefore, the net cash flow in Year 5 is $$1,000 # $22.64 ! $$977.36.
7. Next, we can determine the after-tax cost (or after-tax yield to maturity)
of issuing the bonds. Since the cash flow stream is uneven, the after-tax
yield to maturity is found by entering the after-tax cash flows, shown in
Line 4 of Table 8A-1, into the cash flow register and then pressing the
IRR key on the financial calculator. The IRR is the after-tax cost of zero
coupon debt to the company. Conceptually, here is the situation:
n
CFn
a (1 # k
t!1
n
d(AT) )
! 0.
(8A-4)
$747.26
$17.94
$19.01
$20.15
$21.36
$$977.36
#
#
#
#
#
! 0.
0
1
2
3
4
(1 # kd(AT))
(1 # kd(AT) )
(1 # kd(AT))
(1 # kd(AT))
(1 # kd(AT))
(1 # kd(AT))5
APPENDIX 8A
■
ZERO COUPON BONDS
395
The value kd(AT) ! 0.036 ! 3.6%, found with a financial calculator, produces the equality, and it is the cost of this debt. (Input in the cash flow
register CF0 ! 747.26, CF1 ! 17.94, and so forth, out to CF5 !
$977.36. Then press the IRR key to find kd ! 3.6%.)
8. Note that kd(1 $ T) ! 6%(0.6) ! 3.6%. As we will see in Chapter 10,
the cost of capital for regular coupon debt is found using the formula
kd(1 $ T). Thus, there is symmetrical treatment for tax purposes for zero
coupon and regular coupon debt; that is, both types of debt use the same
after-tax cost formula. This was Congress’s intent, and it is why the Tax
Code specifies the treatment set forth in Table 8A-1.1
The purchaser of a zero coupon bond must calculate interest income on the
bond in the same manner as the issuer calculates the interest deduction. Table
8A-2 shows the resulting tax payments for an investor in the 28 percent tax
bracket who purchases the Vandenberg bond. Given this tax treatment, investors
pay taxes in each year even though they don’t receive any cash flows until the
bond is sold or matures, a situation that many investors find unattractive.
Consequently, because of the tax situation pension funds and other tax-exempt
entities buy most zero coupon bonds. Individuals do, however, buy taxable zeros
for their Individual Retirement Accounts (IRAs). Also, state and local governments issue “tax-exempt muni zeros” that are purchased by individuals in high
tax brackets.
Not all original issue discount bonds (OIDs) have zero coupons. For example, Vandenberg might have sold an issue of five-year bonds with a 5 percent
coupon at a time when other bonds with similar ratings and maturities were
yielding 6 percent. Such bonds would have had a value of $957.88:
5
$1,000
$50
Bond value ! a
! $957.88.
t #
(1.06)
(1.06)5
t!1
If an investor had purchased these bonds at a price of $957.88, the yield to maturity would have been 6 percent. The discount of $1,000 $ $957.88 ! $42.12
would have been amortized over the bond’s five-year life, and it would have
been handled by both Vandenberg and the bondholders exactly as the discount
on the zeros was handled.
Thus, zero coupon bonds are just one type of original issue discount bond.
Any nonconvertible bond whose coupon rate is set below the going market rate
at the time of its issue will sell at a discount, and it will be classified (for tax and
other purposes) as an OID bond.
Shortly after corporations began to issue zeros, investment bankers figured
out a way to create zeros from U.S. Treasury bonds, which at the time were
issued only in coupon form. In 1982, Salomon Brothers bought $1 billion of 12
percent, 30-year Treasuries. Each bond had 60 coupons worth $60 each, which
represented the interest payments due every six months. Salomon then in effect
clipped the coupons and placed them in 60 piles; the last pile also contained the
now “stripped” bond itself, which represented a promise of $1,000 in the year
2012. These 60 piles of U.S. Treasury promises were then placed with the trust
1
Note too that we have analyzed the bond as if the cash flows accrued annually. Generally, to facilitate comparisons with semiannual payment coupon bonds, the analysis is conducted on a semiannual basis.
396
APPENDIX 8A
■
ZERO COUPON BONDS
TABLE
Analysis of a Zero Coupon Bond from Investor’s Perspective
8A-2
BASIC DATA
Maturity value
$1,000
kd
6.00%, annual compounding
Maturity
5 years
Personal tax rate
28.00%
Issue price
$747.26
ANALYSIS
0
(1) Year-end accrued value
1
2
3
4
5 Years
$792.10
$839.62
$890.00
$943.40
$1,000.00
(2) Interest income
44.84
47.52
50.38
53.40
56.60
(3) Tax payment (28%)
12.56
13.31
14.11
14.95
15.85
$12.56
$13.31
$14.11
$14.95
#984.15
(4) Cash flow to investor
$747.26
6%
$747.26
After-tax return
4.32%
department of a bank and used as collateral for “zero coupon U.S. Treasury Trust
Certificates,” which are, in essence, zero coupon Treasury bonds. Treasury zeros
are, of course, safer than corporate zeros, so they are very popular with pension
fund managers. In response to this demand, the Treasury has also created its own
“Strips” program, which allows investors to purchase zeros electronically.
Corporate (and municipal) zeros are generally callable at the option of the
issuer, just like coupon bonds, after some stated call protection period. The call
price is set at a premium over the accrued value at the time of the call. Stripped
U.S. Treasury bonds (Treasury zeros) generally are not callable because the
Treasury normally sells noncallable bonds. Thus, Treasury zeros are completely
protected against reinvestment risk (the risk of having to invest cash flows from
a bond at a lower rate because of a decline in interest rates).
PROBLEMS
8A-1
Zero coupon bonds
8A-2
Zero coupon bonds
8A-3
Zero coupon bonds and EAR
A company has just issued 4-year zero coupon bonds with a maturity value of $1,000 and
a yield to maturity of 9 percent. The company’s tax rate is 40 percent. What is the aftertax cost of debt for the company?
An investor in the 28 percent bracket purchases the bond discussed in Problem 8A-1.
What is the investor’s after-tax return?
Assume that the city of Tampa sold tax-exempt (muni), zero coupon bonds 5 years ago.
The bonds had a 25-year maturity and a maturity value of $1,000 when they were issued, and the interest rate built into the issue was a nominal 10 percent, but with semiannual compounding. The bonds are now callable at a premium of 10 percent over the
accrued value. What effective annual rate of return would an investor who bought the
bonds when they were issued and who still owns them earn if they are called today?
APPENDIX 8A
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ZERO COUPON BONDS
397
8B
BANKRUPTCY AND REORGANIZATION
In the event of bankruptcy, debtholders have a prior claim to a firm’s income
and assets over the claims of both common and preferred stockholders. Further, different classes of debtholders are treated differently in the event of
bankruptcy. Since bankruptcy is a fairly common occurrence, and since it affects both the bankrupt firm and its customers, suppliers, and creditors, it is important to know who gets what if a firm fails. These topics are discussed in this
appendix.1
F E D E R A L B A N K R U P T C Y L AW S
Bankruptcy actually begins when a firm is unable to meet scheduled payments
on its debt or when the firm’s cash flow projections indicate that it will soon be
unable to meet payments. As the bankruptcy proceedings go forward, the following central issues arise:
1. Does the firm’s inability to meet scheduled payments result from a temporary cash flow problem, or does it represent a permanent problem
caused by asset values having fallen below debt obligations?
2. If the problem is a temporary one, then an agreement that stretches out
payments may be worked out to give the firm time to recover and to satisfy everyone. However, if basic long-run asset values have truly declined,
economic losses will have occurred. In this event, who should bear the
losses?
3. Is the company “worth more dead than alive” — that is, would the business be more valuable if it were maintained and continued in operation or
if it were liquidated and sold off in pieces?
4. Who should control the firm while it is being liquidated or rehabilitated?
Should the existing management be left in control, or should a trustee be
placed in charge of operations?
These are the primary issues that are addressed in the federal bankruptcy
statutes.
Our bankruptcy laws were first enacted in 1898, modified substantially in
1938, changed again in 1978, and further fine-tuned in 1984. The 1978 Act,
which provides the basic laws that govern bankruptcy today, was a major reviThis appendix was coauthored by Arthur L. Herrmann of the University of Hartford.
1
Much of the current work in this area is based on writings by Edward I. Altman. For a summary
of his work, and that of others, see Edward I. Altman, “Bankruptcy and Reorganization,” in Handbook of Corporate Finance, Edward I. Altman, ed. (New York: Wiley, 1986), Chapter 19.
398
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B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
sion designed to streamline and expedite proceedings, and it consists of eight
odd-numbered chapters, the even-numbered chapters of the earlier Act having
been deleted. Chapters 1, 3, and 5 of the 1978 Act contain general provisions
applicable to the other chapters; Chapter 7 details the procedures to be followed when liquidating a firm; Chapter 9 deals with financially distressed municipalities; Chapter 11 is the business reorganization chapter; Chapter 13 covers the adjustment of debts for “individuals with regular income”; and Chapter
15 sets up a system of trustees who help administer proceedings under the Act.
Chapters 11 and 7 are the most important ones for financial management
purposes. When you read in the paper that McCrory Corporation or some
other company has “filed for Chapter 11,” this means that the company is
bankrupt and is trying to reorganize under Chapter 11 of the Act. If a reorganization plan cannot be worked out, then the company will be liquidated as
prescribed in Chapter 7 of the Act.
The 1978 Act is quite flexible, and it provides a great deal of scope for informal negotiations between a company and its creditors. Under this Act, a case
is opened by the filing of a petition with a federal district bankruptcy court.
The petition may be either voluntary or involuntary — that is, it may be filed
either by the firm’s management or by its creditors. A committee of unsecured
creditors is then appointed by the court to negotiate with management for a reorganization, that may include the restructuring of debt and other claims
against the firm. (A “restructuring” could involve lengthening the maturity of
debt, lowering the interest rate on it, reducing the principal amount owed, exchanging common or preferred stock for debt, or some combination of these
actions.) A trustee may be appointed by the court if that is deemed to be in the
best interests of the creditors and stockholders; otherwise, the existing management will retain control. If no fair and feasible reorganization can be
worked out under Chapter 11, the firm will be liquidated under the procedures
spelled out in Chapter 7.
FINANCIAL DECISIONS
IN
BANKRUPTCY
When a business becomes insolvent, a decision must be made whether to dissolve the firm through liquidation or to keep it alive through reorganization. To
a large extent, this decision depends on a determination of the value of the firm
if it is rehabilitated versus the value of its assets if they are sold off individually.
The procedure that promises higher returns to the creditors and owners will be
adopted. However, the “public interest” will also be considered, and this generally means attempting to salvage the firm, even if the salvaging effort may be
costly to bondholders. For example, the bankruptcy court kept Eastern Airlines
alive, at the cost of millions of dollars that could have been paid to bondholders, until it was obvious even to the judge that Eastern could not be saved.
Note, too, that if the decision is made to reorganize the firm, the courts and
possibly the SEC will be called upon to determine the fairness and the feasibility of the proposed reorganization plan.
Standard of Fairness
The basic doctrine of fairness states that claims must be recognized in the order
of their legal and contractual priority. Carrying out this concept of fairness in a
reorganization (as opposed to a liquidation) involves the following steps:
APPENDIX 8B
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B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
399
1. Future sales must be estimated.
2. Operating conditions must be analyzed so that the future earnings and
cash flows can be predicted.
3. A capitalization (or discount) rate to be applied to these future cash flows
must be determined.
4. This capitalization rate must then be applied to the estimated cash flows
to obtain a present value figure, which is the indicated value for the reorganized company.
5. Provisions for the distribution of the restructured firm’s securities to its
claimants must be made.
Standard of Feasibility
The primary test of feasibility in a reorganization is whether the fixed charges
after reorganization can be covered by cash flows. Adequate coverage generally
requires an improvement in operating earnings, a reduction of fixed charges, or
both. Among the actions that generally must be taken are the following:
1. Debt maturities are usually lengthened, interest rates may be scaled back,
and some debt may be converted into equity.
2. When the quality of management has been substandard, a new team must
be given control of the company.
3. If inventories have become obsolete or depleted, they must be replaced.
4. Sometimes the plant and equipment must be modernized before the firm
can operate on a competitive basis.
L I Q U I D AT I O N P R O C E D U R E S
If a company is too far gone to be reorganized, it must be liquidated. Liquidation should occur if a business is worth more dead than alive, or if the possibility of restoring it to financial health is so remote that the creditors would face
a high risk of even greater losses if operations were continued.
Chapter 7 of the Bankruptcy Act is designed to do three things: (1) provide
safeguards against the withdrawal of assets by the owners of the bankrupt firm,
(2) provide for an equitable distribution of the assets among the creditors, and
(3) allow insolvent debtors to discharge all of their obligations and to start over
unhampered by a burden of prior debt.
The distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act is governed by the following priority of claims:
1. Secured creditors, who are entitled to the proceeds of the sale of specific property
pledged for a lien or a mortgage. If the proceeds do not fully satisfy the secured creditors’ claims, the remaining balance is treated as a general creditor claim. (See Item 9.)
2. Trustee’s costs to administer and operate the bankrupt firm.
3. Expenses incurred after an involuntary case has begun but before a trustee is appointed.
4. Wages due workers if earned within three months prior to the filing of the petition of bankruptcy. The amount of wages is limited to $2,000 per person.
400
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B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
5. Claims for unpaid contributions to employee benefit plans that were to have
been paid within six months prior to filing. However, these claims, plus
wages in Item 4, are not to exceed the $2,000 per employee limit.
6. Unsecured claims for customer deposits, not to exceed a maximum of $900 per
individual.
7. Taxes due to federal, state, county, and any other government agency.
8. Unfunded pension plan liabilities. Unfunded pension plan liabilities have a
claim above that of the general creditors for an amount up to 30 percent
of the common and preferred equity; any remaining unfunded pension
claims rank with the general creditors.
9. General, or unsecured, creditors. Holders of trade credit, unsecured loans,
the unsatisfied portion of secured loans, and debenture bonds are classified as general creditors. Holders of subordinated debt also fall into this
category, but they must turn over required amounts to the holders of senior debt, as discussed later in this section.
10. Preferred stockholders, who can receive an amount up to the par value of the issue.
11. Common stockholders, who receive any remaining funds.
To illustrate how this priority system works, consider the balance sheet of
Chiefland Inc., shown in Table 8B-1. The assets have a book value of $90 million. The claims are indicated on the right side of the balance sheet. Note that
the debentures are subordinate to the notes payable to banks. Chiefland had
filed for reorganization under Chapter 11, but since no fair and feasible reorganization could be arranged, the trustee is liquidating the firm under Chapter
7. The firm also has $15 million of unfunded pension liabilities.2
The assets as reported in the balance sheet in Table 8B-1 are greatly overstated; they are, in fact, worth about half of the $90 million at which they are
carried. The following amounts are realized on liquidation:
Proceeds from sale of current assets
Proceeds from sale of fixed assets
Total receipts
$41,950,000
5,000,000
$46,950,000
2
Under the federal statutes that regulate pension funds, corporations are required to estimate the
amount of money needed to provide for the pensions that have been promised to their employees.
This determination is made by professional actuaries, taking into account when employees will retire, how long they are likely to live, and the rate of return that can be earned on pension fund assets. If the assets currently in the pension fund are deemed sufficient to make all required payments,
the plan is said to be fully funded. If assets in the plan are less than the present value of expected future payments, an unfunded liability exists. Under federal laws, companies are given up to 30 years
to fund any unfunded liabilities. (Note that if a company were fully funded in 2001, but then agreed
in 2002 to double pension benefits, this would immediately create a large unfunded liability, and it
would need time to make the adjustment. Otherwise, it would be difficult for companies to agree
to increase pension benefits.)
Unfunded pension liabilities, including medical benefits to retirees, represent a time bomb ticking in the bowels of many companies. If a company has a relatively old labor force, and if it has
promised them substantial retirement benefits but has not set aside assets in a funded pension fund
to cover these benefits, it could experience severe trouble in the future. These unfunded pension
benefits could even drive the company into bankruptcy, at which point the pension plan would be
subject to the bankruptcy laws.
APPENDIX 8B
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B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
401
TABLE
Chiefland Inc.: Balance Sheet Just before Liquidation
(Thousands of Dollars)
8B-1
Current assets
$80,000
Net fixed assets
10,000
Accounts payable
Notes payable (to banks)
Accrued wages, 1,400 @ $500
U.S. taxes
700
1,000
300
Current liabilities
$32,000
First mortgage
6,000
Second mortgage
1,000
Subordinated debenturesa
8,000
$15,000
Preferred stock
2,000
Common stock
26,000
Paid-in capital
$90,000
10,000
State and local taxes
Total long-term debt
Total assets
$20,000
4,000
Retained earnings
11,000
Total equity
$43,000
Total liabilities and equity
$90,000
a
Subordinated to $10 million of notes payable to banks.
NOTE: Unfunded pension liabilities are $15 million; this is not reported on the balance sheet.
The allocation of available funds is shown in Table 8B-2. The holders of the
first mortgage bonds receive the $5 million of net proceeds from the sale of
fixed assets. Note that a $1 million unsatisfied claim of the first mortgage holders remains; this claim is added to those of the other general creditors. Next
come the fees and expenses of administration, which are typically about 20 percent of gross proceeds; in this example, they are assumed to be $6 million. Next
in priority are wages due workers, which total $700,000; taxes due, which
amount to $1.3 million; and unfunded pension liabilities of up to 30 percent of
the common plus preferred equity, or $12.9 million. Thus far, the total of
claims paid from the $46.95 million is $25.90 million, leaving $21.05 million
for the general creditors.
The claims of the general creditors total $42.1 million. Since $21.05 million
is available, claimants will initially be allocated 50 percent of their claims, as
shown in Column 2 of Table 8B-2, before the subordination adjustment. This
adjustment requires that the holders of subordinated debentures turn over to
the holders of notes payable all amounts received until the notes are satisfied.
In this situation, the claim of the notes payable is $10 million, but only $5 million is available; the deficiency is therefore $5 million. After transfer of $4 million from the subordinated debentures, there remains a deficiency of $1 million
on the notes. This amount will remain unsatisfied.
Note that 92 percent of the first mortgage, 90 percent of the notes payable,
and 93 percent of the unfunded pension fund claims are satisfied, whereas a maximum of 50 percent of unsecured claims will be satisfied. These figures illustrate
402
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B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
TABLE
DISTRIBUTION
OF
PROCEEDS
ON
Chiefland Inc.: Order of Priority of Claims
8B-2
LIQUIDATION
1. Proceeds from sale of assets
$46,950,000
2. First mortgage, paid from sale of fixed assets
$ 5,000,000
3. Fees and expenses of administration of bankruptcy
6,000,000
4. Wages due workers earned within three months prior to filing of bankruptcy petition
700,000
5. Taxes
1,300,000
6. Unfunded pension liabilitiesa
12,900,000
7. Available to general creditors
DISTRIBUTION
TO
25,900,000
$21,050,000
GENERAL CREDITORS
APPLICATION
OF 50
PERCENTc
(2)
CLAIMb
(1)
CLAIMS OF GENERAL CREDITORS
Unsatisfied portion of first mortgage
$ 1,000,000
Unsatisfied portion of second mortgage
$
500,000
AFTER
SUBORDINATION
ADJUSTMENTd
(3)
$
500,000
PERCENTAGE
OF ORIGINAL
CLAIMS
RECEIVEDe
(4)
92%
1,000,000
500,000
500,000
50
Notes payable
10,000,000
5,000,000
9,000,000
90
Accounts payable
20,000,000
10,000,000
10,000,000
50
Subordinated debentures
8,000,000
4,000,000
0
0
Pension plan
2,100,000
1,050,000
1,050,000
93
$42,100,000
$21,050,000
$21,050,000
a
Unfunded pension liabilities are $15,000,000, and common and preferred equity total $43,000,000. Unfunded pension liabilities have a prior
claim of up to 30 percent of the total equity, or $12,900,000, with the remainder, $2,100,000, being treated as a general creditor claim.
b
Column 1 is the claim of each class of general creditor. Total claims equal $42.1 million.
c
From Line 7 in the upper section of the table, we see that $21.05 million is available for general creditors. This sum, divided by the $42.1 million
of claims, indicates that general creditors will initially receive 50 percent of their claims; this is shown in Column 2.
d
The debentures are subordinated to the notes payable, so $4 million is reallocated from debentures to notes payable in Column 3.
e
Column 4 shows the results of dividing the amount in Column 3 by the original claim amount given in Column 1, except for the first mortgage, for
which the $5 million received from the sale of fixed assets is included, and the pension plan, for which the $12.9 million is included.
the usefulness of the subordination provision to the security to which the subordination is made. Because no other funds remain, the claims of the holders of
preferred and common stock are completely wiped out. Studies of bankruptcy
liquidations indicate that unsecured creditors receive, on the average, about 15
cents on the dollar, whereas common stockholders generally receive nothing.
SOCIAL ISSUES
IN
BANKRUPTCY PROCEEDINGS
An interesting social issue arose in connection with bankruptcy during the
1980s — the role of bankruptcy in settling labor disputes and product liability
suits. Normally, bankruptcy proceedings originate after a company has become
APPENDIX 8B
■
B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
403
so financially weak that it cannot meet its current obligations. However, provisions in the Bankruptcy Act permit a company to file for protection under
Chapter 11 if financial forecasts indicate that a continuation of business under
current conditions will lead to insolvency. These provisions were applied by
Frank Lorenzo, the principal stockholder of Continental Airlines, who demonstrated that if Continental continued to operate under its then-current union
contract, it would become insolvent in a matter of months. The company then
filed a plan of reorganization that included major changes in its union contract.
The court found for Continental and allowed the company to abrogate its contract. It then reorganized as a nonunion carrier, and that reorganization turned
the company from a money loser into a money maker. (However, in 1990, Continental’s financial situation reversed again, partly due to rising fuel prices, and
the company once again filed for bankruptcy.) Under pressure from labor
unions, Congress changed the bankruptcy laws after the Continental affair to
make it more difficult to use the laws to break union contracts.
The bankruptcy laws have also been used to bring about settlements in
major product liability suits, the Manville asbestos case being the first, followed
by the Dalkon Shield case. In both instances, the companies were being bombarded by literally thousands of lawsuits, and the very existence of such huge
contingent liabilities made continued operations virtually impossible. Further,
in both cases, it was relatively easy to prove (1) that if the plaintiffs won, the
companies would be unable to pay off the full amounts claimed, (2) that a
larger amount of funds would be available if the companies continued to operate than if they were liquidated, (3) that continued operations were possible
only if the suits were brought to a conclusion, and (4) that a timely resolution
of all the suits was impossible because of the number of suits and the different
positions taken by different parties. At any rate, the bankruptcy statutes were
used to consolidate all the suits and to reach a settlement under which all the
plaintiffs obtained more money than they otherwise would have gotten, and the
companies were able to stay in business. The stockholders did not do very well
because most of the companies’ future cash flows were assigned to the plaintiffs, but, even so, the stockholders probably came out better than they would
have if the individual suits had been carried through the jury system to a conclusion.
In the Johns-Manville Corporation case, the decision to reorganize was
heavily influenced by the prospect of an imminent series of lawsuits. JohnsManville, a profitable building supplier, faced increasing liabilities resulting
from the manufacture of asbestos. When thousands of its employees and consumers were found to be exposed, Johns-Manville filed for Chapter 11 bankruptcy protection and set up a trust fund for the victims as part of its reorganization plan. Present and future claims for exposure were to be paid out of
this fund. However, it was later determined that the trust fund was significantly underfunded due to more and larger claims than had been originally estimated.
We have no opinion about the use of the bankruptcy laws to settle social issues such as labor disputes and product liability suits. However, the examples
do illustrate how financial projections can be used to demonstrate the effects of
different legal decisions. Financial analysis is being used to an increasing extent
in various types of legal work, from antitrust cases to suits against stockbrokers
by disgruntled customers, and this trend is likely to continue.
404
APPENDIX 8B
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B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
PROBLEMS
8B-1
Bankruptcy distributions
The H. Quigley Marble Company has the following balance sheet:
Current assets
Fixed assets
$5,040
Accounts payable
2,700
540
Accrued taxes
180
Accrued wages
180
Total current liabilities
900
Second mortgage bonds
900
Total mortgage bonds
$1,800
Total debt
8B-2
Bankruptcy distributions
$7,740
$1,980
First mortgage bonds
Subordinated debentures
Total assets
$1,080
Notes payable (to bank)
1,080
$4,860
Preferred stock
360
Common stock
2,520
Total liabilities and equity
$7,740
The debentures are subordinated only to the notes payable. Suppose the company goes
bankrupt and is liquidated, with $1,800 being received from the sale of the fixed assets,
which were pledged as security for the first and second mortgage bonds, and $2,880 received from the sale of current assets. The trustee’s costs total $480. How much will
each class of investors receive?
Southwestern Wear Inc. has the following balance sheet:
Current assets
Fixed assets
$1,875,000
Accounts payable
1,875,000
Notes payable
750,000
Subordinated debentures
750,000
Total debt
Common equity
Total assets
$3,750,000
$ 375,000
Total liabilities and equity
$1,875,000
1,875,000
$3,750,000
The trustee’s costs total $281,250, and the firm has no accrued taxes or wages. The
debentures are subordinated only to the notes payable. If the firm goes bankrupt, how
much will each class of investors receive under each of the following conditions?
a. A total of $2.5 million is received from sale of the assets.
b. A total of $1.875 million is received from sale of the assets.
APPENDIX 8B
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B A N K R U P T C Y A N D R E O R G A N I Z AT I O N
405