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
