The core business of TVL Corporation is undergoing a difficult period. TVL bonds

Question

The core business of TVL Corporation is undergoing a difficult period. TVL bonds have been
downgraded to CCC in order to reflect the higher probability of default the company now faces.
TVL is considering a very promising (high NPV, low risk) capital investment project which, if
successful, will get it out of its current predicament. Financing the project will require issuing
more high-yield debt at a very substantial yield. TVL plans to attach a call provision to its bonds.
a) What is the role of the call provision in the specific case of TVL?
b) What determines the value of a call provision? How will the call provision affect the
pricing of the issue?
c) Do you expect the call provision to be costly to TVL? Explain.

Explanation / Answer

a) The call provision of the bonds is with TVL Corporation, making it a callable bond. This provision will enable TVL to redeem the bond prior to its maturity at the terms and conditions mentioned in the call option.

As TVL is considering a promising capital investment project, its risk will decline and hence the expected rate of interest will also decline. This will make the option of refinancing the debt at lower interst rate attractive for TVL. Hence the call provision.

b) Call price for a bond will be (in most cases) higher than the par value. The value of a call provision in this case is clearly being determined by the savings in interest pay out and the company will calculate the value of call provision keeping that parameter in mind.

As the call provision is higher than par, the pricing will be low initially at the time of issue i.e at a discount. This is prudent as the company is paying a high rate of interest initially.

c) In net terms (keeping in mind the savings from interest reduction), the call provision will not be costly to TVL as the lower interest payments in future will offset the high call price. But yes, the call price (on a standalone basis) will be higher than par.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.