XYZ Company is in awe at the recent change in interest rates. The current intere

Question

XYZ Company is in awe at the recent change in interest rates. The current interest rate on A2 rated bonds is currently at 6 percent. The $30 million, 15-year bond issue that the company has outstanding was initially issued at 9 percent five years ago.

XYZ is considering refunding the bond issue due to this decline. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life.

A. Do a standard bond refunding analysis. Is the refunding financially feasible?


B. In terms of the refunding decision, how should XYZ's CFO be influenced if he thinks interest rates might go down even more?

Explanation / Answer

c. Refunding Decision

Outflows

1. Payment of call premium
$30,000,000 x 10%             = $3,000,000
$3,000,000 x (1 – 40 )         = $1,800,000

2. Underwriting cost on new issue
Actual expenditure $30,000,000 x 4%   =    $1,200,000
Amortization of cost = ($1,200,000/10) =    $120,000
Tax savings of per year $120,000 x .40   =    $48,000
PV of future tax savings $48,000 x 7.722* = $370,656
*PVIFA for n = 10, i = 5%

Actual expenditure=                                                    $1,200,000
PV of future tax savings =                                                $370,656
New cost of underwriting expense on the new issue =   $829,344

3. Cost savings in lower interest rates
11% (interest on old bonds) x $30,000,000 =   $3,300,000
- 8% (interest on new bond) x $30,000,000 =    2,400,000
Savings per year                                      =      $ 900,000

Savings per year $900,000 x (1 – 40) = $540,000 after tax

$ 540,000 * 7.722 (PVA (n = 10, i = 5%)

$4,169,880 Present value of interest savings

4. Underwriting cost on old issue
Original amount (3% x $30,000,000) =                                                       $900,000
Amount written over last 5 years at $60,000 per year ($900,000/15)          $300,000
  
Unamortized old underwriting cost                                                            $600,000                                

Present value of deferred future write-off                                         
$60,000 x 7.722 (n = 10, i = 5%)                                                                    $463,320

Immediate gain in old underwriting write-off                                            $136,680
tax rate
Tax rate                                                                                                              .40
After tax value of immediate gain in old underwriting cost write-off         $ 54,672

                                                               Summary

PV of Outflows

                     1. $1,800,000
                      2.     829,344
PV of Outflows $2,629,344

PV of Inflows

                    3. $4,169,880
                    4.     $54,672

PV of inflows  $4,224,552
  
Net Present Value(outflow - inflow) = $1,595,208

The refunding is financially feasible.

d. If Mike thought interest rates were going down even more, he might want to wait on the refunding because the net present value would be even higher. Of course, if he were wrong and interest rates went up, he might miss out on a highly profitable opportunity.

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