14.CS: Case Study - Financing An Acquisition Through Bonds

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Page ID: 22157

Jean-Paul Olivier
Red River College of Applied Arts, Science, & Technology

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The Situation

Business is booming at Lightning Wholesale! The robust economy and favorable exchange rates have greatly increased the demand for its products. This means that Lightning Wholesale has to increase its inventories immediately to continue providing good service to its customers. Believing this to be a permanent increase in business, the distribution manager decides that the company's existing distribution warehouse simply has too little room to accommodate future needs.

Finding herself in a difficult but positive situation, she asks her commercial property representative to seek a vacant warehouse in the area for immediate occupation. Within a few days, the real estate broker calls back with details. The amount of money required to purchase the new facility along with all installations and equipment is more than the liquid assets of Lightning Wholesale. After examining all available options, the distribution manager suspects that the low rates in the bond market offer the cheapest source of financing.

The Data

Lightning Wholesale needs $9.84 million immediately to proceed with the distribution warehouse acquisition.
The finance department believes it prudent to set a five-year maturity on the bonds.
To ensure the availability of funds and allow for any unplanned cost overruns, Lightning Wholesale will issue bonds in an amount that exceeds the requirement by 2%. All bonds are issued with a $1,000 face value.
At the time of issue, the bond market is expected to have a market rate of 3.37% compounded semi-annually.
The bond is issued with a sinking fund provision that requires semi-annual deposits such that the full amount issued will be available upon maturity to redeem the bonds. Lightning Wholesale is also permitted to use the funds to redeem the bonds at any point if the market provides a favourable opportunity. Estimates from the fund's third-party manager place the interest rate on the fund at 4.15% compounded semi-annually.

Important Information

Unbeknownst to Lightning Wholesale today:

The market rate will rise to 5.65% after three years.
The sinking fund's management will find a better fund earning 4.75% compounded semi-annually after two years.

Your Tasks

Examine the initial structure of the bond issuance and the financial commitments required.
1. How many bonds will be issued?
2. What is the amount of the sinking fund payment?
3. Develop a complete sinking fund schedule and total the expected interest earned. For each payment, note the book value of the bond debt.
4. Calculate the annual cost of the bond debt.
Advance two years into the future and determine the implications of the rate increase for the sinking fund.
1. What is the balance in the sinking fund at this time?
2. What is the new sinking fund payment?
3. Including the past two years' interest, what total interest is now earned?
4. By what amount does the annual cost of the bond debt decrease?
Advance another year into the future where the rate in the bond market has risen substantially to 5.65%.
1. The sinking fund management company decides to use the savings in the sinking fund to redeem as many bonds as possible. Based on your calculations from the previous question, how many bonds will it be able to redeem?
2. After the bonds are redeemed, what is the new sinking fund payment for the last two years?
3. Construct a revised sinking fund schedule for the last two years based on your answers to the above questions.
4. By what amount has the annual cost of the debt increased or decreased (compared to where it was the previous year)?
5. If it is assumed the last two years are uneventful and the bonds are redeemed at maturity, how did the overall cost of the bond issuance change from its initial plan?
Examine this bond issuance from the investor's side.
1. For an investor who acquired 23 of the bonds at the time of the bond issuance, what investor's yield did she realize when the company redeemed the bonds after the three years?
2. An investor acquired 46 of the bonds when it had two years left until maturity. Construct a complete table detailing either the amortization or accrual of the premium or discount.

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