Arden Mills: Callable Bonds and Preferred Stock Financing
Four years ago, Arden Mills issued 12-year, 6.5% semiannual-coupon bonds at a $1,000 par value. The bonds are callable three years from now at a call price of $1,030. Comparable noncallable bonds now yield 7.8% to maturity. The CFO is considering a new financing and asks whether the call feature is valuable to the company and what return an investor should expect. Separately, the firm can issue 6.0% preferred stock at $50 par. Flotation costs on the preferred would be 3% of par, and the marginal tax rate is 25%. The CFO has read that preferred stock is 'expensive' because dividends are not tax-deductible, but she also values its lack of a maturity date and its flexibility in a downturn. She wants the yield calculations and a financing recommendation that considers both cost and risk.
1. Compute the current price of the Arden Mills bond. State the remaining maturity, the semiannual coupon, and the semiannual yield.
Read the worked answer
Remaining maturity = 8 years = 16 semiannual periods. Coupon = 6.5% × $1,000/2 = $32.50. Yield per period = 7.8%/2 = 3.9%. Price = $32.50 × [1 − (1.039)^−16]/0.039 + $1,000/(1.039)^16. (1.039)^16 ≈ 1.8444; discount factor 0.5422. Annuity factor = (1 − 0.5422)/0.039 = 11.738. PV coupons = $381.5; PV principal = $542.2; price ≈ $923.7. The bond trades at a discount because its 6.5% coupon is below the 7.8% market yield. The discount is not a sign of default; it is the market repricing the fixed coupon when rates rose.
2. Compute the yield to maturity and the yield to call, and explain which yield is more relevant to an investor. Is the call feature valuable to Arden?
Read the worked answer
YTM is given as 7.8% (3.9% semiannual) if held to maturity. YTC solves $923.7 = $32.50 × [1 − (1+r)^−6]/r + $1,030/(1+r)^6. At r = 5.2% semiannual, PV coupons ≈ $163.9 and PV call price ≈ $759.9, total ≈ $923.8. So YTC ≈ 10.4% annually. The call is valuable to Arden because it can refinance if rates fall; the firm will call when the call price is cheaper than continuing to pay the coupon. For the investor, YTC is not a promised return; it is the return if the firm calls. Because the bond is priced below par, the call actually raises the investor's return relative to YTM, but it caps price appreciation and creates reinvestment risk. If rates rise, the bond will not be called and the investor earns the lower YTM. The relevant yield depends on the rate scenario; use YTM for 'hold to maturity' and YTC for 'rates fall' analysis.
3. Compute the cost of preferred stock and compare it with the after-tax cost of debt. What qualitative factors should drive the financing choice?
Read the worked answer
Cost of preferred = $3.00/$48.50 = 6.19%. After-tax cost of debt = 7.8% × (1 − 0.25) = 5.85%. On a pure cost basis, debt is cheaper because interest is deductible. But preferred has no maturity, no mandatory sinking fund, and dividends can be suspended (though cumulative features may apply). It also does not add a covenant-heavy claim. If Arden's taxable income is low or volatile, the tax shield is less valuable and the effective cost gap narrows. The recommendation should weigh 34 basis points of extra cost against flexibility and leverage capacity. The callable bond's YTC also matters: if Arden expects rates to fall, it may issue callable debt and refinance; if it wants permanent equity-like capital, preferred may be worth the premium.