Question

Matthew Ltd. is considering expanding and requires a large amount of finance to do so. The company’s CFO reviewed the current financial position and has strongly advised management to use debt rather than equity to raise the necessary funds.

1. Can you explain a possible reason why the CFO would advise debt rather than equity?
2. Matthew Ltd.’s accountant Vanessa has advised management that if the company takes out a loan they may be subject to positive covenants. Describe what positive covenants are and provide two examples.

   A few years ago Matthew Ltd. issued a $100 000 corporate bond which was paying semi-annual coupons at a rate of 6.25% p.a. That bond currently has 6 years to maturity and the current market yield of 4.30% p.a.

3. Calculate the current price of the bond. Is this bond now selling at a premium or at a discount?

4. The company accountant, Vanessa, is a share market investor and has been looking closely at possibly investing some of her personal money into a company called ABC Ltd. Her required rate of return is 10% and ABC Ltd. paid a dividend of $4 this year and is expected to grow their dividends by 3% each year forever.

   Calculate the value of an ABC Ltd. share given the information above

Answer 1

1.
The CFO would not want to dilute the ownership and increase the cost of capital

2.
Positive covenant is a kind of promise or contract requiring the borrowing party to maintain certain level of standard /stability for business, affirming company’s financial health &well-being

Examples: Maintain certain specified limit of ratios, Keep in check insurance policies affecting business, Pay taxes

3.
Price=Par value*coupon rate/yield*(1-1/(1+yield/2)^(2*t))+Par value/(1+yield/2)^(2*t)=100000*6.25%/4.30%*(1-1/(1+4.30%/2)^(2*6))+100000/(1+4.30%/2)^(2*6)=110216.6083

As Price is more than par, it is a premium bond

4.
Price=D0*(1+g)/(r-g)
=4*(1+3%)/(10%-3%)
=58.8571