Reference no: EM132192403

CASES

This is a take-home exam. You may not discuss this exam or receive any type of help from anyone except me. Please list any outside sources that you use to complete this exam. The exam must be uploaded to Moodle by 4PM on Thursday, December 13.

The exam is a case study. There are three companies involved in the case. You are assumed to be working for one of the companies (Clifton Corp.). I have tried to provide all necessary information to solve the questions. If it seems like something was left out, you can contact me. Make sure you submit your exam in the form of a case write-up (rather than as a problem set).

Overview: Each of the companies faces a financing decision. As part of a solution to that decision, the companies explore a swap transaction with each other. Your assignment is to analyze the financing decision and the swap decision.

PART 1. CONVERTIBLE BOND ANALYSIS

Clifton Corp.
Clifton is a commercial real estate company. Clifton has a major property development in the works and is planning to issue $100 million bonds to finance development. Clifton is also planning an equity offering help pay for the project.

Clifton typically rents to commercial clients and annual rents are closely tied to short-term interest rate changes. As a result, Clifton prefers to borrow at floating rates.

Clifton's bankers are recommending a novel strategy. Rather than issue floating-rate debt and equity, Clifton can issue a fixed-rate convertible bond and then enter into an interest rate swap that converts the fixed payments into a floating rate. The bankers tell Clifton that this will produce tax savings because Clifton will be able to deduct the full cost of a non-convertible bond from its taxes even though the actual interest cost is lower. Clifton's tax rate is 35%. Bankers believe the appropriate volatility to use for Clifton's stock is 30%. Clifton's stock price is currently $50/share. It does not pay a dividend.
Clifton's bond credit rating is A.
Clifton's bankers suggest the following terms:
• $1,000 face value/bond
• Priced at 100% of par value
• 0.75% fee to the investment bank
• $125,000 in expenses charged to Clifton
• 10-year maturity
• Coupon rate 4.0%
• Convertible into 16.667 shares of Clifton common stock at any time by the purchaser during the first three years. Not convertible after 3 years.

You are hired as a consultant by Clifton's corporate finance department. They want an outside opinion about the value of the bonds. Clifton doesn't want to sell bonds at more than a 4% discount to fair value. Clifton also wants to identify the equity component of the offering.

1. What is your best estimate of the fair value of the bonds?
2. Should Clifton issue the bonds?
3. Calculate the present value of the tax savings Clifton will see if the bonds are converted after three years.
4. Calculate the present value of the tax savings Clifton will see if the bonds are not converted and mature in 10 years.
5. Using the delta of the embedded options, estimate the current value of amount of equity Clifton is issuing in the deal.
6. In your opinion, would Clifton be better off issuing non-convertible floating rate debt or following through with this deal as planned?

PART 2. SWAP ANALYSIS

In addition to Clifton, the swap analysis involves the following two companies.
Maywood Merchandise

Maywood is a clothing manufacturer that has experienced steady profits but little growth in recent years. Its credit rating is BBB but Maywood has been notified by credit agencies that their rating may be lowered in the near future. Maywood is looking to issue $100 in 10-year bonds to finance a new factory. Maywood prefers to issue fixed-rate debt, but their bankers are recommending issuing a floating-rate bond and then entering into an interest rate swap to convert its floating rate obligation into a fixed rate. The bankers explain that there is currently very strong demand for floating-rate bonds, and that Maywood can save interest costs using this strategy. The bankers propose the following terms for Maywood:
• $1,000 face value/bond
• Priced at 99.0% of par value
• 1.00% fee to the investment bank
• $100,000 in expenses charged to Maywood
• 10-year maturity
• Floating-rate coupon at LIBOR + 0.50%, semi-annual payments

Park Avenue Bank
Park Avenue advises both Maywood and Clifton. Park Avenue is also a swap dealer, and can serve as the swap counterparty between Maywood and Clifton. Park Avenue is AAA-rated.

1. Analyze the interest rate spreads in tables 1 and 2. Is there any evidence to support the bankers' claim that there is strong demand for floating-rate debt?

2. Analyze a potential swap between Maywood and Clifton (with Park Avenue in the middle). What is the potential interest savings for both companies. How big is the ‘pie'. Can both companies save money with the swap?

3. Now assume that you are asked by Clifton to negotiate the terms of the swap. How much of the pie do you think you will be able to get for Clifton? What are your reasons why Clifton should get a big piece of the pie? How much will Maywood and Park Avenue get? What are their reasons for getting a big slice?

4. Explain which company controls this deal.

CONCLUSION

What are the risks in this deal? Who is getting the best outcome? Who is taking a lot of risk without getting much in return?

Attachment:- Derivative Cases.rar