What are the advantages to Gonzales of making the bonds callable?
A few years after the initial expansion, Gonzales wants to build a plant and finance an operation that would manufacture and distribute its homemade salsa and related products to supermarkets throughout the United States and Mexico. Mr. Gonzales, CEO and family head, has begun planning this venture, even though construction is not expected to begin until the current expansion is complete and the company is financially stable, which might take several years. Even so, Mr. Gonzales has some ideas that he would like you to examine.
The projects estimated cost is $30 million, which will be used to build a manufacturing facility and to set up the necessary distribution system. Gonzales tentatively plans to raise the $30 million by selling 10-year bonds, and its investment bankers have indicated that the firm can use either regular or zero coupon bonds. Regular coupon bonds would sell at par and would have annual payment coupons of 12 percent; zero coupon bonds would also be priced to yield 12 percent annually. Either bond would be callable after three years, on the anniversary date of the issue. What is your suggestion for stage II expansion? In doing so, you should answer the following questions:
a. Suppose Gonzales issues bonds and uses the manufacturing facility (land and buildings) as collateral to secure the issue. What type of bond would this security be? Suppose that instead of using secured bonds, Gonzales decides to sell debentures. How would this choice affect the interest rate that Gonzales would have to pay on the $30 million of debt?
b. What is a bond indenture? What are some typical provisions that the bond- holders would require Gonzales to include in its indenture?
c. Gonzaless bonds will be callable after three years. If the bonds were not callable, would the required interest rate be higher or lower than 12 percent? What would be the effect on the rate if the bonds were callable immediately? What are the advantages to Gonzales of making the bonds callable?
d. What are some factors that a firm such as Gonzales should consider when deciding whether to issue long-term debt, short-term debt, or equity? Why might long-term debt be the companys best choice for this project?