Problem 1: If the economy continues to be strong, Carson Company might require increasing its production capacity by about 50 percent over the upcoming few years to satisfy demand. It would need financing to expand and accommodate the raise in production. Recall which the yield curves is currently upward sloping. Also recall that Carson is concerned regarding a possible slowing of the economy due to potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering issuing stock or bonds to increase funds in the upcoming year.
a. Suppose that Carson has two choices to satisfy the increased demand for its products. It could raise production by 10 percent with its existing facilities through obtaining short-term financing to cover the extra production expenditure 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 purchase a larger facility which would allow for 50 percent more capacity. Which alternative should Carson select?
b. Carson currently has a large amount of debt, and its assets have already been pledged to back up its existing debt. It doesn’t 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 which the cost of financing is the same in both markets?
c. Should Carson consider using a call provision when it issues bonds? Why? Why may Carson decide not to comprise 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 sort of investor might be interested in participating in a private placement? Do you think Carson could provide the same yield on a private placement as it could on a public placement? Describe.
e. Financial institutions such as insurance companies and pension funds commonly buy bonds. Describe the flow of funds that runs through these financial institutions and ultimately reaches corporations that issue bonds such as Carson Company.