Question

Cornwall Corporation is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT? a. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond. b. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future. c. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan. d. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds. e. If two tiers of debt are used (with one senior and one subordinated debt class), the subordinated debt will carry a lower interest rate.

Answer 1

The correct answer in this case would be: d. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds.

This is because if the mortgage bond is of lower value and the entire plant is hypothecated for the same, then it carries lower risk compared to the plant hypothecated for a larger debt value.