Question

Twenty years ago ABC Inc. took out a $100 million loan with an interest rate of 6 percent compounded quarterly over its 35 year life. With interest rates now so low, ABC is now looking to potentially refinance the loan.

1. The accounting department would like to know how much interest was paid on this loan last year
2. If new debt with an interest rate of 4.75 percent compounded quarterly can be raised with a 2 percent flotation cost, should they refinance this loan?

Answer 1

Given:

Time Period completed - 20 years

Time Period remaining - 15 years

Interest rate - 6%

Principle amount - 100 million

The interest paid on this loan last year: 100,000,000*(((1+6/(4*100))^4) - 1) [The time is taken as 4n, and rate as r/4, due to quarterly compounding]

= 100,000,000*(((1.015)^4) - 1)

=100,000,000* 0.0614

=6,140,000$

Floatation cost - 2%

As, no information has been given with respect to the share price or method of raising the new debt, we assume that the floatation cost is on the principle amount.

Thus, one time payable floatation cost = 0.02*100,000,000 = 2,000,000$

The interest payable with the new interest rate of 4.75%, is calculated as:

=100,000,000* (((1+(4.75/(4*100)))^4) - 1)

= 100,000,000*((1.012^4)-1)

= 100,000,000* 0.0489

=4,890,000$

Thus total amount paid if refinanced in the first year = 4,890,000+2,000,000

=6,890,000$

While this amount is greater than the interest paid on the initial loan, refinancing this loan is the best option. This is because, the flotation cost is a one time payment. After the first year, only the interest of 4,890,000$ needs to be paid, which is lower than the current interest.