Section B – TWO questions ONLY to be attempted Levante Co has identified a new project for which it will need to increase its long-term borrowings from $250 million to $400 million. This amount will cover a significant proportion of the total cost of the project and the rest of the funds will come from cash held by the company. The current $250 million borrowing is in the form. of a 4% bond which is trading at $98·71 per $100 and is due to be redeemed at par in three years. The issued bond has a credit rating of AA. The new borrowing will also be raised in the form. of a traded bond with a par value of $100 per unit. It is anticipated that the new project will generate sufficient cash flows to be able to redeem the new bond at $100 par value per unit in five years. It can be assumed that coupons on both bonds are paid annually. Both bonds would be ranked equally for payment in the event of default and the directors expect that as a result of the new issue, the credit rating for both bonds will fall to A. The directors are considering the following two alternative options when issuing the new bond: (i) Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to ensure full take up of the bond; or (ii) Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and equal to its par value. The following extracts are provided on the current government bond yield curve and yield spreads for the sector in which Levante Co operates: Required: (a) Calculate the expected percentage fall in the market value of the existing bond if Levante Co’s bond credit rating falls from AA to A. (3 marks) (b) Advise the directors on the financial implications of choosing each of the two options when issuing the new bond. Support the advice with appropriate calculations. (7 marks) (c) Among the criteria used by credit agencies for establishing a company’s credit rating are the following: industry risk, earnings protection, financial flexibility and evaluation of the company’s management. Briefly explain each criterion and suggest factors that could be used to assess it. (8 marks)