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Refunding Analysis Lecture 10112022 014637pm

The document discusses whether a company should refund its $60 million bond issue that has a 12% annual coupon rate and 20 years remaining. Refunding would involve calling the old bonds and replacing them with new 20-year bonds at 9% interest. Doing so would lower interest costs but require paying a call premium and flotation costs for the new bonds. The analysis calculates the investment outlay, annual interest savings, and net present value of refunding to determine if it would be profitable.

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123 views11 pages

Refunding Analysis Lecture 10112022 014637pm

The document discusses whether a company should refund its $60 million bond issue that has a 12% annual coupon rate and 20 years remaining. Refunding would involve calling the old bonds and replacing them with new 20-year bonds at 9% interest. Doing so would lower interest costs but require paying a call premium and flotation costs for the new bonds. The analysis calculates the investment outlay, annual interest savings, and net present value of refunding to determine if it would be profitable.

Uploaded by

dua nadeem
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Refunding is Replacing an old debt issue with a new one, usually to lower the i

Refunding means calling the issue and replacing it with a new issue of bonds. I

Microchip Computer Company has a $60 million bond issue outsta


that the firm has been amortizing on a straight-line basis over the
10% call premium. Investment banks have assured the company tha
debt will be available, the new bonds will be sold 1 month before th
term interest rates are unlikely to fall below 9%. Flotation costs on

Solution
Data
Old Issue

Out standind bonds


C.R
N
Remaining Life
Flotation Cost
Call Premium

Step 1
i

ii
iii

iv

Total After Tax Investment Outlay

Step 2

Tax Saings on flotation costs on the New Issue

Tax benefit Lost on flotation cost on the Old issue

Net Flotation Amortization Tax Effect

Step 3

Step 4

PV=

Discounting Factor (After tax Cost of New Debt)


PV of Flotation Cost Savings
PV of Annual Interest Savings

Step 4

PV of Flotation Cost Savings


PV of Annual Interest Savings
Net Investment Outlay
NPV from refunding
Refunding A
debt issue with a new one, usually to lower the interest cost.
sue and replacing it with a new issue of bonds. In this regard, we focus our attention on only one reason

Mini Case S
mpany has a $60 million bond issue outstanding that has a 12% annual coupon interest rat
mortizing on a straight-line basis over the 25-year original life of the issue. The bond has a c
ment banks have assured the company that it could sell an additional $60 million to $70 mil
new bonds will be sold 1 month before the old issue is called; thus, for 1 month the compan
ikely to fall below 9%. Flotation costs on a new refunding issue will amount to $2,650,000, a
bonds?

New Issue

60,000,000 New issue


12% N
25 I.R
20 year Short term Interest Rate
3,000,000 Flotation Cost
10%
Tax

Determine the Investment Outlay required to refund the issue


Call premium on old issue Formula Text
Before Tax Call premium 6,000,000 =60000000*0.1
After-Tax Call Premium 3,600,000 =6000000*(1-40%)
Savings 2,400,000
Floatation Cost on New Issue 2,650,000
Floatation Cost on Old Issue
Unamortized Flotation Cost 2400000
After Tax Savings 960000
Additional Interest One month extra i
Interest Cost 360000 =60000000*(12%/12)*(1-40%)

However proceeds from new issue


Interest earned 180,000

Call Premium - 3,600,000


Flotation Cost, New Issue -2,650,000
Flotation Cost, Old Issue, Tax Savings 960,000
Net Addition Interest -180,000
Total Investment - 5,470,000

Calculate The Annual Flotation Cost Tax Effects

ngs on flotation costs on the New Issue

Annual Tax Deduction 132500 =2650000/20


Tax Savings per Year 53000 Annuity Payment

enefit Lost on flotation cost on the Old issue


Unamortized cost/N 120,000
After Tax Benefit (Annual) 48000

Net Flotation Amortization Tax Effect


5000 per year for 20 years

Calculation of Annual Interest Savings

Interest on Old bond after Tax 4,320,000


Interest on New Bond, After Tax 3,240,000
Net Annual Interest Savings 1,080,000

Calculation of NPV of the Refunding


PVs of the benefits

P* (1-(1+i)^-n)/i)

5.4% =9%*(1-40%)
60251
13014174

NPV from Refunding Operations

60251
13014174
-5,470,000
7604425
unding Analysis
on only one reason for refunding – profitability – which, in turn, is due to interest rates have declined si

Mini Case Study:


upon interest rate and 20 years remaining to maturity. This issue, which was sold 5 years a
The bond has a call provision that makes it possible for the company to retire the issue at th
million to $70 million worth of new 20-year bonds at an interest rate of 9%. To ensure that
month the company will have to pay interest on two issues. Current short-term interest rate
nt to $2,650,000, and the firm’s marginal federal-plus-state tax rate is 40%. Should the com
bonds?

60,000,000
20
9%
6%
2,650,000

40%
One month extra interest on the old issue, after tax costs
2%/12)*(1-40%)

proceeds from new issue can be invested for 1 month, thus, $ 60 million invested at rate of 6% will return after tax interest
nufatima.buic@bahria.edu.pk
t rates have declined since the bonds were issued.

h was sold 5 years ago, had flotation costs of $3 million


retire the issue at this time by calling the bonds in at a
9%. To ensure that the funds required to pay off the old
rt-term interest rates are 6%. Predictions are that long-
0%. Should the company refund the $60 million of 12%
after tax interest

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