Question

XYZ Corp. is considering refunding its old debt now that interest rates have dropped.

	Old Bonds	New Bonds
Original Life:	10 Years	5 Years
Par Value:	1 Million	1 Million
Coupon Rate:	8 % annual	6% annual
Call premium	10%
Flotation Costs	$40,000 original	$45,000
Age of Bonds	5 years	0 years
Tax Rate 40%

Additionally, XYZ will have to borrow $1 million for 15 days (1/2 month) in order to cover itself between the time it buys back the old debt and sells the new debt. The annualized interest rate on this short-term borrowing is 9 percent. Should XYZ perform the refunding?

Answer 1

		STEP1
		Discount Rate =After Tax cost of new debt
		Interest rate for the new Bond	6.00%
		Flotation cost of new Bond as percentage	4.50%	(45000/1000000)
		Before tax cost of new debt=6/(1-0.045)=	6.28%
		Tax Rate =40%
		After tax cost of new debt =6.28*(1-0.4)	3.77%
		DISCOUNT RATE	3.77%
		STEP2
		Present Value (PV) of total outflows:
		Investment Outlay:
		Call Premium on old bond=10%
		Before tax Call Premium paid on old bond=$1million*10%	($100,000)
	B	After tax Call Premium paid on old bond=100000*(1-0.40)	($60,000)
	C	Flotation cost on new bond=	($45,000)
		Flotation cost incurred on old bond	$40,000
		Number of years to maturity of old Bond	10
		Annual amortization=40000/10	$4,000
		Unamortized underwriting cost =4000*5=	$20,000
	D	immediate tax saving on unamortized underwriting cost =20000*0.4	$6,000
		Before tax cost of short term borrowing=1000000*9%*(1/24)	($3,750)	(15 days=1/24 Year)
	E	After tax cost of short term borrowing=3750*(1-0.4)	($2,250)
	G=B+C+D+E	Present Value (PV) of total Cash Outflow	($101,250)
		STEP3
		Present Value of total inflows
		Annual Tax Shield on amortization expense of Flotation cost (New Bond)	$3,600	(45000/5)*40%
		Tax Shield lost on amortization expense of Flotation cost Old Bond)	($1,600)	(40000*40%)
	H	Net annual tax shield on amortization cost of Flotationexpenses	$2,000
		After tax interest savings on old issue=$1million*8%*(1-0.4)	$48,000
		After tax interest cost on new bond=$1million*6%*(1-0.4)	($36,000)
	I	Net annual interest savings	$12,000
	Pmt=H+I	Net Annual Cash inflows	$14,000
	Rate=STEP1	Discount Rate	3.77%
	Nper	Number of Years	5
	PV	Present Value (PV)of total inflows	$62,731	(Using PV function of excel with Rate=3.77%, Nper=5, Pmt=-14000)
		NET PRESENT VALUE
	NPV=PV+G	Net Present Value =62731-101250	($38,519)
		NET PRESENT VALUE IS NEGATIVE
		XYZ SHOULD NOT PERFORM REFUNDING