Financing in the Bond Markets:
If the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for sup- plies. It is also considering issuing stock or bonds to raise funds in the next year.
a. Assume that Carson has two choices to satisfy the increased demand for its products. It could increase pro- duction by 10 percent with its existing facilities by obtaining short-term financing to cover the extra pro- duction expense and then using a portion of the revenue received to finance this level of production in the future. Alternatively, it could issue bonds and use the proceeds to buy a larger facility that would allow for 50 percent more capacity. Which alternative should Carson select?
b. Internet/Excel Exercise Go to finance.yahoo.com/bonds and click on “Composite Bond Rates.” Compare the rate of a 10-year Treasury bond to a 10-year municipal bond. Which type of bond would offer you a higher annual yield b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon? Why? c. Offer one reason why you might not select the investment that would have the highest expected return over the one-year investment horizon. 2. Inflation-Indexed Treasury Bond Assume that the U.S. economy experienced deflation during the year and that the consumer price index decreased by 1 percent in the first six months of the year and by 2 percent during the second six months of the year. If an investor had purchased inflation-indexed Treasury bonds with a par value of $10,000 and a coupon rate of 5 percent, how much would she have received in interest during the year? b. Carson currently has a large amount of debt, and its assets have already been pledged to back up its existing debt. It does not have additional collateral. At this time, the credit risk premium it would pay is similar in the short-term and long-term debt markets. Does this imply that the cost of financing is the same in both markets?
c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson decide not to include a call provision on the bonds?
d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a private placement of bonds? What type of investor might be interested in participating in a private placement? Do you think Carson could offer the same yield on a private placement as it could on a public placement? Explain.
e. Financial institutions such as insurance companies and pension funds commonly purchase bonds. Explain the flow of funds that runs through these financial institutions and ultimately reaches corporations that issue bonds such as Carson Company.