Tombstones – Case Solution

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Tombstones Case Answers

1. Microsoft Notes:

Microsoft raised $4.75 billion in unsecured notes to help fund the company’s business; namely, it planned to use the capital for “general corporate purposes, which may include funding for working capital, capital expenditures, repurchases of stock and acquisitions.”

Despite this offering being only the second in Microsoft’s history and the significant cash held on their balance sheet, they recognized a unique opportunity to take advantage of incredibly low-interest rates and strong investor appetite for high-quality debt.

This paper is considered cheap by historical standards due to the perceived quality and credibility of Microsoft, in addition to the low-interest-rate environment in 2010.  In September 2010, short-term rates traded near zero, and 30-year bonds traded below 4%, this is much lower than September 2006, when the yield curve traded above 5% across most maturities.

The 3-year issue represented $1.0B notes due in 2013 with an annual coupon of 0.875%, paid semi-annually, priced at 99.835% of the principal amount for a YTM of 0.931%; the 5-year issue represented $1.75B notes due in 2015 with an annual coupon of 1.625%, paid semi-annually, priced at 99.561% of the principal amount for a YTM of 1.717%; the 10-year issue represented $1.0B notes due in 2020 with an annual coupon of 3.000%, paid semi-annually, priced at 99.136% of the principal amount for a YTM of 3.101%; the 30-year issue represented $1.0B notes due in 2040 with an annual coupon of 4.500%, paid semi-annually, priced at 98.911% of the principal amount for a YTM of 4.567%.

The yield to maturity is the effective annual rate of return for a bond, which includes measures of returns from coupons, capital gains or losses, and the reinvestment of coupons at the calculated YTM.  The YTM calculation utilizes coupons, which represent the amount that the company pays investors in each period, often with an annual or semi-annual frequency.

We can compare YTM to the internal rate of return (IRR) because it can be thought of as the rate that equates the price of the bond to the present value of the bond’s cash flows.  Microsoft issued four papers for multiple reasons, including a desire to satiate investor appetite for a variety of maturities.

By offering notes at different yields, they were able to serve buyers with varying investment horizons and space out the times at which the large principal payments were due.  Since Microsoft issued these notes at such a low rate, we find it unlikely that they will be called or redeemed.  It may make sense for them to call or redeem the bonds if they were able to refinance at a lower cost of capital.

2. Coca Cola Enterprise Notes:

Coca-Cola Enterprises, looking to take advantage of the low-interest-rate environment following the financial crisis, issued two series of notes. One was a 3-year issue due 2012 with a principal amount of $350m, paying an annual coupon of 3.750%, and the other was a 5-year issue due 2015 with a principal amount of $250m, paying an annual coupon of 4.250%.

Given this information, we are able to compute the yields to maturities on the 3-year and 5-year issues, which are 3.896% and 4.650%, respectively. With regard to the MFST issue stated above, investors priced the Coca-Cola issue much less favorably.

For comparable duration bonds, such as each company’s 3-year notes, MFST was able to issue much more debt with a lower coupon and have a lower YTM than Coca-Cola. MFST issued $1.0bn with a 0.875% annual coupon with a YTM of .931%, whereas Coca-Cola’s 3-year issue was $350m with a 3.750% coupon and a YTM of 3.896%.

These differences occurred for a couple of reasons.

First, MFST had a…