Your firm, New Horizons, needs to raise capital for an upcoming project that will cost $50,000,000 to complete. You have consulted your investment banker and are looking at raising the money through your first capital raise in the bond market. Being new to the market, you will need the services of a rating agency to help determine the approximate interest costs that will be necessary for your company to raise the capital.
After a thorough review of your company’s financials and all the necessary documentation, the rating agency decides that your bond would likely receive a bond rating of either A- and BBB+. You, as CFO of the firm, decide to issue a plain vanilla, semi-annual pay, coupon bond. Your capital project necessitates that you borrow the required capital for a period of 10 years.
The current US Treasury yield curve displays the following rates:
Nominal US Treasury Rates
3 month (4.00%), 6 month (4.20%), 1 year (4.5%), 2 year (4.75%), 3 year (4.9%), 5 year (5.1%), 10 year (5.4%), 30 year (5.9%).
Credit Spreads for 10-year Corporates Similar to New Horizon:
AAA (0.4%), AAA- (0.5%), AA+ (0.6%), AA (0.80%), AA- (0.90%) A+ (1.0%), A (1.1%), A- (1.25%), BBB+ (1.55%), BBB (1.7%), BBB- (1.9%).
Answer the following questions:
1. What is the nominal risk-free rate?
2. If the anticipated inflation rate is 2%, what is the real risk-free rate?
3. Would the maturity premia for the New Horizon bond be?
4. What is the default premia for the New Horizon bond be if the rating agency gave it a A- rating?
5. Complete the following equation for the New Horizon bond: a. YTM = r* + h + mp + dp What is the YTM of the New Horizons issue if the rating agency gave the bond of A-? Fill in each component of the YTM.
6. What is the most likely coupon rate that New Horizon will issue on its debt? (Remember that most bonds are priced around par at issuance)? Set the coupon rate to the nearest quarter point.
7. Given that coupon rate and YTM, at what price will the bond be issued if it gets an A- rating when issued? How much money will be raised if the company issues $50,000,000 in par value? Does New Horizons raise the needed $50,000,000 at the YTM and price? If not, how many more bonds must they sell to raise the required amount?
8. What would the YTM be for the bond if it received a BBB+ rating? What would be the coupon and price of the New Horizon bond be at the new yield? How many bonds would New Horizon have to sell to raise the necessary capital?
9. What is the total interest cost difference over the life of the bonds for New Horizons between raising $50,000,000 by issuing a bond with an A- rating vs. an BBB+ rating?