Question 1. Delaware Steel Company has $100 million of 13 percent debentures outstanding. The indenture (loan covenants) limits additional borrowing such that the total interest coverage (EBIT/interest) is at least three times. Delaware's EBIT last year was $52 million. How much could Delaware borrow under a term loan at 13 percent interest without breaching the indenture restriction?
Question 2. O'Dowell Tool and Machine Company is about to sell a $100 million issue of bonds. The covenants on the loan require that O'Dowell maintain a coverage of its interest plus sinking fund of 2.5 to 1 (remember, a sinking fund payment is the same as a principle payment). The bonds are to be retired over the next 20 years by equal yearly sinking-fund payments and carry an interest rate of 10% per year. What is the lowest level to which O'Dowell's EBIT can drop in the first year the bonds are issued without violating the covenants of the loan? O'Dowell's tax rate is 40%.
Remember, interest is paid in before-tax dollars while sinking fund payments are made in after-tax dollars. Each dollar of interest payment requires just one dollar of EBIT to cover it, but to pay a dollar in sinking-fund payment in after-tax dollars requires $1.67 of EBIT [before-tax dollars]. After paying 40% tax on $1.67, there will be $1.00 left to cover the sinking fund. Thus, to cover one dollar of interest plus one dollar of sinking fund would require $2.67 of EBIT ($1.00 for the interest plus $1.00 times 1.67 for the sinking fund payment); to cover one dollar of interest plus $0.50 of sinking fund payment would require $1.84 of EBIT.
Question 3. Carter Manufacturing Company has outstanding an issue of 9 percent sinking-fund debentures which requires an annual sinking-fund payment of $4 million per year. This requirement may be met either by:
1. presenting to the trustee on or before a specified date each year cash in the amount of $4 million; or else
2. instructing the trustee to enter the financial markets and purchase for Carter's account enough bonds to equal a face value of $4 million, which it will then cancel and retire.
The same number of bonds will be retired in either case. In the first case, the bonds will be acquired and retired at face value. In the second, the bonds to be retired will be purchased from the market at market price.
A. Each bond has a face value of $1000, pays interest once per year, and has five years left to maturity. Presently, the bonds are trading in the market with a yield to maturity of 12.0 percent. What will the market price of the bonds be?
B. Enough bonds must be retired to satisfy the $4,000,000 sinking fund requirement? either by having the trustee acquire the 4,000 bonds to be retired at their $1,000 face value (par value) or else purchase the 4,000 bonds to be retired in the market at market price. Which of the two methods should Carter use to meet the current sinking-fund payment due shortly?