1. New York Water (NYW) is considering whether to refund a $50 million, 14 perce
ID: 2696444 • Letter: 1
Question
1. New York Water (NYW) is considering whether to refund a $50 million, 14 percent coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 million of flotation costs on the 14 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 11.67 percent in today's market. A call premium of 14 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NYW's marginal tax rate is 40 percent. The new bonds would be issued at the same time the old bonds were called.
a. What is the relevant refunding investment outlay?
b. What are the relevant annual interest savings for NYW if refunding takes place?
c. What are the relevant annual flotation cost tax effects for NYW if refunding takes place?
d. What is the NYW bond refunding's NPV?
2. The following data apply to Saunders Corporation's convertible bonds:
Maturity: 10 Stock price: $30.00
Par value: $1,000.00 Conversion price: $35.00
Annual coupon: 5.00% Straight-debt yield: 8.00%
a. What is the bond's conversion ratio?
b. What is the bond's conversion value?
c. What is the bond's straight-debt value?
d. Based on your answers to the three preceding questions, what is the minimum price (or "floor" price) at which the Saunders' bonds should sell?
Explanation / Answer
a. Here are the current costs affecting the refunding cash outlay:
The call premium is paid on the par value of the original bond issue: $50 MM * 14% = 7MM
The recognition of the remaining $2,500,000 floatation cost of the original bonds will be accelerated. The immediate tax shield benefit of this acceleration = $2.5 MM * 40% = $1.0 MM. Only the tax shield affect is a current cost, the cash paid at issue of the bond is a sunk cost.
The Floatation cost of the new bonds is $3.0 MM.
Total refunding outlay: $7.0 MM - $1.0 MM + $3.0 MM = $9.0 MM
b. The original interest payments were $7.0 MM annually. The new interest payments are $5.835 MM The annual savings is $1.165 MM.
c. The annual tax effect due to the refunding is the tax effect of the change in amortized floatation costs. $3.0 MM straight line amortized over 25 years is $120,000 per year versus $100,000 per year for the original bond
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