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David Wright, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company corporate bond. He has collected the following balance sheet and income statement information for Montrose as shown in Exhibit 10.10. He has also calculated the three ratios shown in Exhibit 10.11, which indicate that the bond is currently rated “A” according to the firm’s internal bond-rating criteria shown in Exhibit 10.13. Wright has decided to consider some off-balance-sheet items in his credit analysis, as shown in Exhibit 10.12. Specifically, Wright wishes to evaluate the impact of each of the off-balance-sheet items on each of the ratios found in Exhibit 10.11.

a. Calculate the combined effect of the three off-balance-sheet items in Exhibit 10.12 on each of the following three financial ratios shown in Exhibit 10.11.

i. EBITDA/interest expense

ii. Long-term debt/equity

iii. Current assets/current liabilities

The bond is currently trading at a credit premium of 55 basis points. Using the internal bond-rating criteria in Exhibit 10.13, Wright wants to evaluate whether or not the credit yield premium incorporates the effect of the off-balance-sheet items.

b. State and justify whether or not the current credit yield premium compensates Wright for the credit risk of the bond based on the internal bond-rating criteria found in Exhibit 10.13.

Exhibit 10.10 Montrose Cable Company Year Ended March 31, 2011 (US$ Thousands)

Balance Sheet

Current assets

$ 4,735

Fixed assets

43,225

Total assets

$47,960

Current liabilities

$ 4,500

Long-term debt

10,000

Total liabilities

$14,500

Shareholders’ equity

33,460

Total liabilities and shareholder’s equity

$47,960

Income Statement

Revenue

$18,500

Operating and administrative expenses

14,050

Operating income

$ 4,450

Depreciation and amortization

1,675

Interest expense

942

Income before income taxes

$ 1,833

Taxes

641

Net income

$ 1,192

Exhibit 10.11 Selected Ratios and Credit Yield Premium Data for Montrose

EBITDA/interest expense

4.72

Long-term debt/equity

0.30

Current assets/current liabilities

1.05

Credit yield premium over U.S. Treasuries

55 basis points

Exhibit 10.12 Montrose Off-Balance-Sheet Items

Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $995,000.

Montrose has sold $500,000 of accounts receivable with recourse at a yield of 8 percent.

Montrose is a lessee in a new non-cancelable operating leasing agreement to finance transmission equipment. The discounted present value of the lease payments is $6,144,000 using an interest rate of 10 percent. The annual payment will be $1,000,000.

Exhibit 10.13 Blue River Investments: Internal Bond-Exhibit 10.13 Blue River Investments: Internal Bond-Rating Criteria and Credit Yield Premium DataRating Criteria and Credit Yield Premium Data

Balance Sheet

 

Current assets

$ 4,735

Fixed assets

43,225

Total assets

$47,960

Current liabilities

$ 4,500

Long-term debt

10,000

Total liabilities

$14,500

Shareholders’ equity

33,460

Total liabilities and shareholder’s equity

$47,960

Income Statement

 

Revenue

$18,500

Operating and administrative expenses

14,050

Operating income

$ 4,450

Depreciation and amortization

1,675

Interest expense

942

Income before income taxes

$ 1,833

Taxes

641

Net income

$ 1,192

 

 

Bond Rating AA BB Interest Coverage (EBITDA/interest expense) 5.00 to 6.00 4.00 to 5.00 3.00 to 4.00 2.00 to 3.00 Credit Yield Current Ratio (Current Premium over Leverage assets/current U.S. Treasuries (in basis points) liabilities) Long-term debt/equity 30 bps 1.15 to 1.25 0.25 to 0.30 1.00 to 1.15 50 bps 0.30 to 0.40 100 bps 0.40 to 0.50 0.90 to 1.00 125 bps 0.50 to 0.60 0.75 to 0.90

 

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