Question

The company has a $300 million debt, with an annual coupon rate of 14% and a remaining life of 10 years. The indenture allows redemption at the call premium of 5%. Suppose the firm can issue a new debt of $250 million with the coupon rate of 11.5%. Flotation cost of the new bond issue is $2.75 million. There is two months overlap, and Pygmalion’s tax rate is 36%, cost of capital is 20% and the T-bill rate is 9%.

What is the cost of refunding the debt?

What is the benefit of refunding the debt?

Should the company refund the debt?

Answer 1

Cost of refunding the debt -

Floatation Cost on after tax basis = 2.75×.64=1.76m ( It is assumed that flotation cost will be debited to this year's profit and loss account and will therefore save 36% tax)

Call Premium = (5% of 250m)0.64 = 8m ( It is again assumed that call Premium will be allowed for tax purposes and hence will save us 36% tax). Further we assumed that with 250m new debt, firm will be able to repay only 250m old debt and not 300m.

Overlapping interest ie it will take 2 months to retire the old debt as new debt is not available instantly, hence for those two months interest will be paid on old debt as well = 250m×14%×2/12×0.64=3.73m

So total costs = 13.49m

Benefits of refunding old debt

Saving of interest ie 14-11.5=2.5% on 250m *0.64=4m for next 10 years. We need to calculate the PV of this annuity @20% which is equal to 16.77m

Since benefits exceeds the costs hence old debt should be refunded and net benefit will be 16.77-13.49=3.28m