Answer to Question #12148 in Management for John

Question

4. Suppose a new company decides to raise a total of $200 million, with $100 million as common
equity and $100 million as long-term debt. The debt can be mortgage bonds or debentures, but
by an iron-clad provision in its charter, the company can never raise any additional debt beyond
the original $100 million. Given these conditions, which of the following statements is
CORRECT?
a. The higher the percentage of debt represented by mortgage bonds, the riskier both types of
bonds will be and, consequently, the higher the firm’s total dollar interest charges will be.
b. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage
bonds, we could be certain that the firm’s total interest expense would be lower than if the
debt were raised by issuing $100 million of debentures.
c. In this situation, we cannot tell for sure how, or whether, the firm’s total interest expense on
the $100 million of debt would be affected by the mix of debentures versus first mortgage
bonds. The interest rate on each of the two types of bonds would increase as the percentage
of mortgage bonds used was increased, but the result might well be such that the firm’s total
interest charges would not be affected materially by the mix between the two.
d. The higher the percentage of debentures, the greater the risk borne by each debenture, and
thus the higher the required rate of return on the debentures.
e. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage
bonds, we could be certain that the firm’s total interest expense would be lower than if the
debt were raised by issuing $100 million of first mortgage bonds.

Answer 1

The CORRECT Statement is C. The fact is that a company canot decrease its total
debt of $100 million by the mix of debentures and mortgage bonds, if this way
exists at all, we can observe the situation of the increase in debentures' risk
when mortgage debt rises. Also the issue of mortgage bonds causes the growth of
mortgage bonds' risk. Thus the Weighted Average Cost of Debt will probably stay
constant enough.