FIN 534 RANK Change The World /fin534rank.com FIN 534 RANK Change The World /fin534rank.com | Page 57

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.
5. Cosmic Communications Inc. is planning two new issues of 25-year
bonds. Bond Par will be sold at its $1,000 par value, and it will have a
10% semiannual coupon. Bond OID will be an Original Issue Discount