Question

Mike Smith, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company Corporate bond. He has collected the balance sheet and income statement information for Montrose, as shown in Exhibit. He has also calculated the three ratios shown in Exhibit, which indicate that the bond is currently rated “A,” according to the firm’s internal bond-rating criteria shown in Exhibit. Smith has decided to consider some off-balance-sheet items in his credit analysis, as shown in Exhibit 19.26. Specifically, Smith wishes to evaluate the impact of each of the off-balance-sheet items on each of the ratios found in Exhibit.
Balance Sheet
Current assets ................. $ 4,735
Fixed assets .................... 43,225
Total assets .................. $47,960
Current liabilities ................. $ 4,500
Long-term debt ................ 10,000
Total liabilities ................. $14,500
Shareholder’s equity .............. 33,460
Total liabilities and shareholder’s equity ...... $47,960
Income Statement
Revenue ................... $18,500
Operating and administrative expenses ....... 14,050
Operating income ................ $ 4,450
Depreciation and amortization ........... 1,675
Interest expense ............... 942
Income before income taxes ........... $ 1,833
Taxes .................... 641
Net income ................. $ 1,192
In Exhibit Selected Ratios and Credit Yield Premium Data for Montrose
EBITDA/interest expense ........... 4.72
Long-term debt/equity ............. 0.30
Current assets/current liabilities .......... 1.05
Credit yield premium over U.S. Treasuries ..... 55 basis points
In Exhibit Montrose Off-Balance-Sheet Items
• Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $995,000.
• Montrose has sold $500,000 of accounts receivable with recourse at a yield of 8 percent.
• Montrose is a lessee in a new noncancelable operating leasing agreement to finance transmission equipment. The discounted present value of the lease payments is $6,144,000, using an interest rate of 10 percent. The annual payment will be $1,000,000.


a. Calculate the combined effect of the three off-balance-sheet items in Exhibit 19.26 on each of the following three financial ratios shown in Exhibit 19.25.
(1) EBITDA/interest expense
(2) Long-term debt/equity
(3) Current assets/current liabilities
The bond is currently trading at a credit premium of 55 basis points. Using the internal bond-rating criteria in Exhibit 19.27, Smith wants to evaluate whether or not the credit yield premium incorporates the effect of the off-balance-sheet items.
b. State and justify whether or not the current credit yield premium compensates Smith for the credit risk of the bond, based on the internal bond-rating criteria found inExhibit.


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  • CreatedDecember 17, 2014
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