Question

Pygmalion Inc. 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%.

a) What is the cost of refunding the debt?

b) What is the benefit of refunding the debt?

c) Should Pygmalion Inc. refund the debt?

Answer 1

Existing issue					new issue
Current issue outstanding			300000000		amount		250000000
coupan rate			14%		maturity		10	years
remaining life			10	years	coupon rate		11.50%
call premuium			5%		Over lapping period of refunding		2	months
					T-bill rate		9%
					Flotation cost of the new bond issue		27500000
					flotation cost per year		2750000	(27500000/10)
					tax rate		36%

Step 1
Calculation of initial cash outlay is:
Call premium paid on existing bond				-15000000	(300000000 *5%)
tax effect ( if call premium is tax deductible)				5400000	(15000000*36%)
Flotation cost paid on new bond issue(upfront)				-27500000
Interest on old bonds for overlap period
($300,000,000 x 14% x 3/12)				-7000000
tax effect	( 10500000*36%)			2520000
interest income received on new issue( 9%)
T bills	($250,000,000 x 9% x 3/12)			3750000
tax effect	(5625000*36%)			-1350000
Question 1
Total initial cost of refunding				-39180000
Step 2
The net annual cash flows
Interest on old bonds				42000000
(300000000*14%)
Interest on new bonds
($250,000,000 x 11.5%)				28750000
interest cost savings				13250000
tax effect @36%				-4770000
net interest cost savings				8480000
flotation cost per year on new bonds				2750000
flotation cost per year on old bonds				0
incremental flotation cost ( new - old)				2750000
tax effect ( tax savings @36%)				990000
Total annual net cash flow savings				9470000	(8480000+990000)
Question 2
step 3
cash flow summary
The net present value associated with the refunding is:
					20%
Year	particulars				PV@20%
0	initial outlay		-39180000		-39180000
1-10'	The net annual cash flows		9470000		39702711
			NPV		522710.7
Question 3
NPV is positive company can refund the debt.

Please provide feed back to my answer. thank you in advance.