Question

Dillon Inc., an American company, is contemplating offering a new $100 million bond issue to replace an
outstanding $100 million bond issue. The company wishes to take advantage of the decline in interest
rates that has occurred since the initial bond issuance. The old and new bonds are described in what
follows. The company is in the 30% tax bracket. The company expects to pay overlapping interest for
three months.
Old bonds: The outstanding bonds have a $1,000 face value and an 8% coupon interest rate. They were
issued five years ago with a 20-year maturity. They were initially sold at their par value of $1000, and the
company incurred $450,000 in floatation costs. They are callable at $1,080.
New bonds: The new bonds would have a $1,000 face value, a 6% coupon interest rate, and a 15-year
maturity. They could be sold at their face value. The flotation cost of the new bonds would be $500,000.
(i) Determine the total initial investment that is required to recall the old bonds and issue the new bonds.

(ii) Calculate the annual cash flow savings, if any, that are expected from the proposed bond-refunding
decision.

(iii) If the company has a 4.2% after-tax cost of debt, find the net present value (NPV) of the bond-
refunding decision. Would you recommend the proposed refunding? Explain your answer.

Answer 1

Answer :

(i) Calculation of  total initial investment that is required to recall the old bonds and issue the new bonds

Total initial investment that is required to recall the old bonds and issue the new bonds will Equal to :

After tax cost of the call premium that is required to retire the old bonds + Flotation cost of the new bonds - Tax savings that are expected from the unamortized portion or the old bonds' flotation cost.

So,

Before tax cost of the call premium that is required to retire the old bonds = (1,080 - 1,000) x 100,000 = $ 8,000,000

a) After tax cost of the call premium that is required to retire the old bonds = $ 8,000,000 - 30% = $ 5,600,000

b) Flotation cost of the new bonds = $ 500,000

c) Tax savings that are expected from the unamortized portion or the old bonds' flotation cost = ( 450,000 x 15/20) x 30% = $ 101,250

Total initial investment that is required to recall the old bonds and issue the new bonds = $5,600,000 + $500,000 - $101,250 = $ 5,998,750

(ii) Calculation of annual cash flow savings that are expected from the proposed bond refunding decision.

Old bond

(a) Before tax Interest cost =   (100,000,000 x 8%) = $ 8,000,000

After-tax interest cost = $ 8,000,000 - 30% = $5,600,000

(b) Tax savings from amortization of floatation cost = ( $ 450,000 / 20) x 30% = $ 6,750

Annual after-tax debt payment under old bond = $ 8,000,000 - $ 6,750 = $ 7,993,250

New bond

(a) Before tax Interest cost = ( $ 100,000,000 x 6%) = $ 6,000,000

  After-tax interest cost = $ 6,000,000 - 30% = $ 4,200,000

(b) Tax savings from amortization of floatation cost = ( $500,000 / 15) x 30% = $ 10,000

Annual after-tax debt payment under New bond = $ 6,000,000 - 10,000 = $ 5,990,000

Annual cash flow savings = $ 7,993,250 - $ 5,990,000 = $ 2,003,250

So, Annual cash flow savings that are expected from the proposed bond refunding decision = $2,003,250

(iii) Calculation of Net present value of the bond refunding decision

Annual cash flow savings that are expected from the proposed bond refunding decision = $2,003,250

Present value = 2,003,250 x { [1-(1+0.042)-15 / 0.042]} = $ 2,003,250 x 10.9645 = $ 21,964,635

Less: Initial investment = ($ 5,998,750)

Net present value = $ 15,965,885