Can someone please help me answer every thing that is being asked in this questi
ID: 2451110 • Letter: C
Question
Can someone please help me answer every thing that is being asked in this question? It would be greatly appreciated. Thank you.
"Please put together a memo to your Board of Directors, as the Company's CFO, which describes some of the risks associated with your Board's plans to raise capital by issuing bonds to the public. Please be sure to include the effects of inflation as well as provide the definition and some examples of liquidity risk, default risk, and tax-related risk, along with any other issues that you believe the Board should consider."
Explanation / Answer
Risk to a corporate by issuing bonds to the public are:
Risk
Should your company get into rough financial water and you're forced into bankruptcy, you pay bondholders first, because they are creditors. This means that bonds are less risky for the investor compared to stock.
Financial Risk
When you issue bonds, the only thing you provide your bondholder with is a promise for repayment. With stock, you provide ownership. Thus, when you issue bonds, you can't avoid increasing your overall debt and taking on debt risk. You must pay the interest even in years where the company is struggling, and when the bond matures, you have to pay the full face value. The inability to meet this obligation can force you into bankruptcy, which has its own host of negative ramifications.
Public Perception
When you offer bonds and increase your debt risk, the public may not perceive the acquisition of debt positively. Because investors generally like to see that a company has some cash or cash equivalents on hand, they might see your actions as a sign that the company is strapped for cash, particularly if your company does not have a good bond rating. People may walk away not only from the bonds, but from stocks and your products, as well.
Collateral
In some cases, in order to provide some assurance to investors, you might have to offer some of the business's assets as collateral for the bonds. If you don't pay the interest or the face value of the bonds as agreed, you may lose those assets. This may make it hard to continue to do business and ultimately may mean the company has to fold.
Risk of investing in bond from an investors perspective is given below which covers the risk given in the question:
Inflation Risk
When an investor buys a bond, he or she essentially commits to receiving a rate of return, either fixed or variable, for the duration of the bond or at least as long as it is held.
But what happens if the cost of living and inflation increase dramatically, and at a faster rate than income investment? When that happens, investors will see their purchasing power erode and may actually achieve a negative rate of return (again factoring in inflation).
Put another way, suppose that an investor earns a rate of return of 3% on a bond. If inflation grows to 4% after the bond purchase, the investor's true rate of return (because of the decrease in purchasing power) is -1%.
Credit/Default Risk
When an investor purchases a bond, he or she is actually purchasing a certificate of debt. Simply put, this is borrowed money that must be repaid by the company over time with interest. Many investors don't realize that corporate bonds aren't guaranteed by the full faith and credit of the U.S. government, but instead depend on the corporation's ability to repay that debt. Investors must consider the possibility of default and factor this risk into their investment decision. As one means of analyzing the possibility of default, some analysts and investors will determine a company's coverage ratio before initiating an investment. They will analyze the corporation's income and cash flow statements, determine its operating income and cash flow, and then weigh that against its debt service expense. The theory is the greater the coverage (or operating income and cash flow) in proportion to the debt service expenses, the safer the investment.
Liquidity Risk
While there is almost always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond.
Low interest in a particular bond issue can lead to substantial price volatility and possibly have an adverse impact on a bondholder's total return (upon sale). Much like stocks that trade in a thin market, you may be forced to take a much lower price than expected to sell your position in the bond.
Tax related risks
Tax risk on bonds is most pronounced during times of high interest rates and high inflation. If, for example, the inflation rate is 3 percent, and your bonds are paying 3 percent, you are just about breaking even on your investment. You have to pay taxes on the 3 percent interest, so you actually fall a bit behind.But suppose that the inflation rate were 6 percent and your bonds were paying 6 percent. You have to pay twice as much tax as if your interest rate were 3 percent (and possibly even more than twice the tax, if your interest payments bump you into a higher tax bracket), which means you fall even further behind.