Question

Waste Management, Unlimited (WM) has a $220 million, 9.2% coupon (paid semiannually), outstanding bond issue, which matures in exactly 8 years, and WM is considering refunding the debt. The call price per $1,000-par-value bond is $1,092. The replacement debt would have a 7.76% coupon (paid semiannually). The firm's tax rate is 30%. What is the net advantage to refunding (NA) in this case?

Answer 1

Initial investment to refund bond = after-tax call premium on old bond (premium is tax deductible)

Call premium on old bond = ((call price per bond - par value per bond) / par value per bond) * total par value

call premium on old bond = ((1092 - 1000) / 1000) * 220,000,000 = $20,240,000

After-tax call premium = call premium on old bond * (1 - tax rate) = $20,240,000 * (1 - 30%) = $14,168,000

Initial investment to refund bond =  $14,168,000

Annual after-tax interest on old bond = total par value of old bond * coupon rate * (1 - tax rate)

Annual after-tax interest on old bond = $220,000,000 * 9.20% * (1 - 30%) = $14,168,000

Annual after-tax interest on new bond = total par value of old bond * coupon rate * (1 - tax rate)

Annual after-tax interest on new bond = $220,000,000 * 7.76% * (1 - 30%) = $11,950,400

Net after-tax interest savings =  $14,168,000 - $11,950,400 = $2,217,600

Present value of Net after-tax interest savings is calculated using PV function in Excel :

rate = 7.76% (required return is assumed to be new coupon rate, in the absence of other information in the question)

nper = 8 (8 years of interest savings)

pmt = 2,217,600 (yearly after-tax interest savings)

PV is calculated to be $12,860,639

Initial investment to refund bond =  $14,168,000

Net advantage to refunding = Present value of Net after-tax interest savings - Initial investment to refund bond

Net advantage to refunding =  $12,860,639 - $14,168,000 = -$1,307,361