Case Solution

Lyons Document Storage Corporation Case Analysis

1. Before maturity, a bond may be selling at the face value or at a price greate
r or lesser than the face value.The terms premium and discount refer to the differen
ce that exists from the face value of the bond. Bonds selling at a price greater
than the face value are said to be at a premium and the bonds selling at a pric
e lesser than the face value are said to be at a discount.
Premium or discount occurs when nominal interest rate(or coupon rate) of the bon
d differs from the current market rate of interest demanded by lenders.Regardles
s of the required yield, the bond price will reach face value as its approaches
the maturity date.
The bond with a face value of $1000 is issued at a discount price of $907.992
* The amount received by Lyons from its 8% bonds if the rate prevailing at the t
ime of original issue was 9 % is
=$ $907.992*10,000
=9,079,920.78
Present Value of $1 | | At 8% | Discounted value of the bond at the ti
me of issue
At 9% |
Received Semiannually for 20 years | 19.79277 | 18.40158 |
Received at the end of 20 years | 0.208289 | 0.171929 |
P.V. of Coupon Earned | 791.711 | 736.0634 |
P.V. of Redemption Value | 208.289 | 171.9287 |
Total | | 1000 | 907.9921 |
* The recomputed amount in the balance sheet in December,2006 and December,2007
are $9,258,589.55 and $9,292,611.26.
* The current value of the bonds outstanding at the current effective rate of 6%
is = $1,154.15*10,000
= $11,541,502.41
Present Value of $1 | | Premium price of the bond reflecting the 6% bo
nd market yield
At 6% |
Received Semiannually for 10.5 years | 15.41502 |
Received at the end of 10.5 years | 0.537549 |
P.V. of Coupon Earned | 616.601 |
P.V. of Redemption Value | 537.5493 |
Total | | 1154.15 |
2.
a. Effect on Cash flows
The current market yield is 6% and if Lyons issues new bonds at 6% coupon, each
bond will fetch $1000.In order to refinance the old debt, Lyons will have to iss
ue 10000 new bonds to raise $10,000,000.However,current market value of the old
debts is $11,541,502.41,so the balance $1,541,502 will be spent out of the compa
nys cash resources.
b. Effect on Current years earnings
From the point of view of the income statement, the current year earnings would
decrease by $2.24 million ($11.54million - $9.3 million).
c. Effect on future years earnings
Future year earnings on the other hand would increase by $200,000 per annum till
January 2019 due to savings in the interest of 2% (8% bonds to 6% bonds) and th
e number of interest payments would reduce by 1 (since July 2019 coupon payment
wont be required) thus saving $400,000 for that period .
Present Value of $1 | | At 8% | At 6% | Difference |
Received Semiannually for 10.5 | 15.41502414 | - | |
Received Semiannually for 10 years | - | 14.87747 | Saving on Inte
rest
|
Redemption Value of $1 after 10.5 years | 0.537549276 | - | |
Redemption Value of $1 after 10 years | - | 0.553676 | Saving on Prin
cipal
|
P.V. of Coupon Earned on $1000 bond | 616.6009655 | 446.3242 | 170.27
67196 |
P.V. of Redemption Value of $1000 bond | 537.5492759 | 553.6758 | -16.12
64783 |
Total | | 1154.150241 | 1000 | 154.1502414 |
Saving in principal by issuing new bonds = -16.12*10000
= -$ 161,264.78 (loss)
Saving in Interest Payments = 170.27*10000
= $1,702,767.20
Therefore we see that it will cost less in terms of principal if we keep the exi
sting bonds, whereas in terms of interest payments it will cost less to issue ne
w bonds at a lower rate.
In order to refund the old bonds entirely by issue of new bonds, Lyons has to is
sue 11,542 bonds with 6% coupon rate paid annually.
3. Taking into account the time value of money, the present value of the 2 optio
ns (issuing new bonds or continuing with existing bonds) is the same. It is up t
o Rene Cook or the firms ideology to decide which option to go for.
Decision to issue new bonds at 6%
Also the number of bonds issued does make any difference on increasing the savin
gs of the firm.(assuming the interest rate to remain at 6% p.a. from 2008 to 201
9)
Option a Option b
No. of Bonds Issued | 10000 |
Interest Payment | $ 4,463,242.46 |
Principal | $ 5,536,757.54 |
Total | $ 10,000,000.00 |
No. of Bonds Issued | 11542 |
Interest Payment | $ 5,151,474.45 |
Principal | $ 6,390,525.55 |
Total | $ 11,542,000.00 |
Under option a:
The firm issues 10,000 bonds worth $10mn.at 6% and retires bonds worth $11.54mn,
thereby having to incur immediate loss worth $1.54mn. However this is recouped
over the 10 year period by savings incurred on interest rate payments. Hence net
effect of this is zero.
Under option b:
The firm issues 11,542 bonds worth $11.54mn at 6%and uses the proceeds to retire
bonds worth $11.54, thereby incurring no profit or loss. However it doesnt make
any savings on interest payment after issuing bonds at 6%, since the number of b
onds issued (11,542) is greater than 10,000.
Though the net effect of the 2 options is the same, we would recommend that if R
ene Cook decides to go ahead with restructuring, she should issue 11,542 bonds a
nd use the proceeds to refund the existing bond. This would prevent any upfront
payment that would result in shrinking of the 2009 projected earnings, slow the
growth rate in earnings and reflect poorly in the current years statement (which
the case states Mr. Lyons would be unhappy about)