Question

New York Water (NYW) is considering whether to refund a $5 million, 12 percent coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $300,000 of flotation costs on the 12 percent bonds over the 30-year life of that issue. NYW's investment bankers have indicated that the company could sell a new 25-year issue at an interest rate of 9 percent in today's market. A call premium of 10 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $400,000. NYW's marginal tax rate is 40 percent. The new bonds would be issued at the same time the old bonds were called.

What is the relevant refunding investment outlay at t=0?

		$425,000
		$500,000
		$600,000
		$750,000
		$800,000

What are the relevant annual interest savings for NYW if refunding takes place?

		$50,000
		$70,000
		$90,000
		$115,000
		$125,000

What are the relevant annual flotation cost tax effects for NYW if refunding takes place?

		$800
		$1,000
		$1,500
		$2,400
		$3,000

What is the NYW bond refunding's NPV?

		$525,641
		$651,635
		$729,962
		$824,258
		$858,334

Answer 1

Given data (numbers in $1,000 except %):
Existing bond issue	5,000	New bond issue	5,000
Flotation cost	300	Flotation cost	400
Maturity (years)	30	Maturity (years)	25
Years since issue	5	New cost of debt	9.0%
Call premium (%)	10%	After-tax cost of debt	5.4%
Original coupon rate	12%	Tax rate	40%

Initial outlay:

Formula	(In $ 000's)	Before-tax	After-tax
Old bond amount*call premium; After-tax = before-tax*(1-tax rate)	Call premium on the old bond	(500)	(300)
It cannot be expensed immediately so after-tax = before-tax	Flotation cost of new issue	(400)	(400)
(Number of years remaining/total maturity)*flotation costs; After-tax = before-tax*tax rate	Tax saving on old flotation cost expense	250	100
	Total after-tax investment		(600)

a). Initial outlay at t = 0 is $600,000.

b). Annual interest savings:

(In $ 000's)	Annual interest savings due to refunding:	Before-tax	After-tax
Before tax: Debt amount*interest rate; After tax: Before-tax*(1-tax rate)	Interest paid on new bond (a)	(450.00)	(270.00)
Before tax: Debt amount*interest rate; After tax: Before-tax*(1-tax rate)	Interest paid on old bond (b)	600.00	360.00
(a+b)	Net interest savings		90.00

Annual interest savings = 90*1000 = $90,000

c). Annual flotation cost effect:

(In $ 000's)	Annual flotation cost effect:	Before-tax	After-tax
Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual tax savings from new issue flotation costs (a)	16.00	6.40
Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual lost tax savings from old issue flotation costs (b)	(10.00)	(4.00)
(a+b)	Net flotation cost savings		2.40

Annual flotation cost effect = 2.4*1000 = $2,400

d). Refunding NPV = initial outlay + Present Value (PV) of annual interest savings + PV of flotation cost effect

PV of annual interest savings:

PMT = 90; N = 25 (new bond maturity); I = 5.4% (after-tax cost of debt of new bond); solve using PV function.

PV = 1,219.12 (in $ 000s)

PV of flotation cost effect:

PMT = 2.40; N = 25 (new bond maturity); I = 5.4% (after-tax cost of debt of new bond); solve using PV function.

PV = 32.51 (in $ 000s)

Total NPV = -600 + 1,219.12 + 32.51 = 651.63 (in $000s) or $651,635