Senior debt

[Eveline]

Hi David,

Can you help me with these 2 questions please?

Consider an all-equity firm with equity capitalization of $2 billion. The firm's CFO considers the following three financing strategies:

1) Issue zero-coupon senior debt with principal amount of $1 billion payable in 10 years and purchase insurance for $100 million that pay losses on the senior debt to investors in excess of $500 million.
2) Issue zero-coupon junior debt with principal amount of $500 million payable in 10 years and issue zero-coupon senior debt with principal amount of $500 million payable in 10 years
3) Issue zero-coupon senior debt with principal amount of $1 billion payable in 10 years with a put option attached that gives the right to investors to put the debt to the firm at maturity for the principal amount.

Which of these strategies will have the most risky senior debt?

A) Strategy 1
B) Strategy 2
C) Strategy 3
D) Senior debt is equally risky in all 3 strategies.

The answer is C.

 

[David Harper CFA FRM]

Hi Eveline,

The question seems a little imprecise; risky to who? in what way? ...but it seems catered to Stulz where "risky debt" is lower in value and more likely to default.
(2) gives the senior debt *subordination* which is protection: the junior debt will suffer losses before the senior debt. So both (1) and (2) give protection

(3) is strange, to me: as the principal is due at maturity to the investors, such a put appears to add no functionality to a plain vanilla zero (i.e., they effectively already have a put at maturity ... this would be valuable if it could be put prior to maturity)...so, unless i miss something, that is just a trick to confuse, the put is redundant, and you are left with the equivalent of a plain vanilla zero. So by elimination, it's the only one without some enhancement/credit protection...David