Case Study:

Accounting

Lyons

Document

Storage

Corporation:

Bond

Executive Summary: Lyons Company, initially a family business

engaged in stationary supply business, shifted to present business of
providing documents storage services to corporates, and thus M/s Lyons
Document Storage Corporation was incorporated in 1993.
To cater to the growing business and face the competitors, the company
had to invest in securing storage space and transportation equipment
and to fund the requirement, company issued debt in 1999 as follows:
Bonds: $10 million in 20 year bonds, coupon rate 8% annually, paid semiannually, yield 9% market rate of interest.
In December 2008, Mr. David Lyons, president of the company intends to
issue the following debt:
Bonds: $10 million for 10 years, coupon rate 6% annually, paid semiannually, yield 6% market rate of interest.
Mr. David Lyons, intends to pay off the old bonds with the proceeds of the
proposed issue and thus cost of funds and improve the cash flows.

Key facts:
Present semiannual cash outflow on account of interest payments:
$300,000/Proposed semiannual cash outflow on account of interest payment:
$200,000/Current outstanding liability in the books: $9.3 million (against issued debt
of $10 million)

Current Problem:
1. Why the outstanding debt in the books is $9.3 million, against the
issued debt of $10 million. Explain what is meant by the terms
premium or discount as they relate to bonds. Compute exactly
how much the company received from its 8% bonds if the rate
prevailing at the time of the original issue was 9%. Also, re-compute
the amounts shown in the balance sheet at December 31,2006 and
December 31, 2007, for long term Debt. What is the current market

value of the bonds outstanding at the current effective interest rate

of 6%?
2. Would you recommend issuing $10 million, 6% bonds on January 2,
2009 and using the proceeds and other cash to refund the existing
$10 million 8% bonds? Will it cost more, in terms of principal and
interest payments to keep the existing bonds or to issue new ones
at a lower rate? Be prepared to discuss the impact of a bond
refunding on the following areas:
(i)
Cash Flows
(ii)
Current years earnings
(iii) Future year earnings
Solution:
Issue Price
1000
Semi annual coupon
payment
40
ROI
4.50%
20yea
Period
rs
$907.
NPV of bond
99
Total no. of bonds issued: 10,000
Total amount collected: 10,000*908=90,80,000, i.e $9.08 million
As can be seen from above, bond was issued at discount, i.e against issue
price of $1000 per bond, only $908 was collected. The same happens
when the market rate of interest (yield) is more than the annual coupon
on bond. In actual, price of bond moves inverse to market rate of interest.
That is when market ROI is high then the price of the bond is low, and vice
versa.
Contrary to above, when the bond is sold at higher price than issue price
(i.e sold at more than $1000 per bond), then the bond is said to be sold at
premium. The same happens when the market rate of interest (Yield) is
less than the annual coupon on bond.
When the market rate of interest (i.e Yield) is equal to the annual coupon,
the bond is said to be issued at par.
Now, in December 2008:
Period left for the existing bonds to mature: From January 2009 to July
2019 = 10.5 years

Thus, NPV of $1000 bond, at coupon 8% annual, paid semiannually,

market ROI 6% annual: $1154.15
Total funds required to purchase outstanding 10,000 bonds at existing
market price: 1154.15*10000
=$1,15,41,500/- i.e
$11.54 million---------------(1)
Since new bonds are proposed to be issued at 6% coupon and 6% market
rate of interest, bonds will be issued at par.
No. of bonds to issued:10,000
Price of a bond: $1000
Total amount to be collected: 10000*1000= $1,00,00,000/- i.e $10
million---------------------(2)
Difference amount [(1)-(2)] of $1.54 million has to be paid from retained
earnings.
Thus, it can be concluded from the above calculations that although
Future cash flows of the firm will improve, the company will have to shell
out $1.54 million extra from its own pocket, which will be a loss making
proposition.