Solution fundamentals of corporate finance brealy 4th chapter text solutions ch 13
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Solutions for Chapter 13
An Overview of Corporate Financing
1.
a.
Authorized share capital = 100,000. Presently 20,000 shares are issued and
outstanding. So 80,000 more shares can be issued without approval of
shareholders.
b.
After new issue;
Book value of common stockholders’ equity (figures in thousands)
Common Shares
$110
Retained Earnings
30
Net Common Equity
140
Note:
100
Authorized Shares
30
Issued Shares
2.
The cost of the share repurchase is $5 x 1000 = $5,000. If the average issue price
of these share was $ 5, the common shares account would be reduced by $5,000.
The company’s accounts in the books would appear as follows:
Common shares
Retained earnings
Net common equity
$ 55,000
30,000
85,000
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Copyright © 2006 McGraw-Hill Ryerson Limited
3.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
Funded
Eurobond
Subordinated
Sinking fund
Call
Prime rate
Floating rate
Private placement, public issue
Lease
Convertible
Warrant
4.
a.
b.
c.
True.
False.
True.
5.
Preferred stock is like long-term debt in that it commits the firm to paying the
security holder a fixed sum — either a specified coupon payment in the case of
bonds or a specified dividend in the case of preferred stock. Like equity and
unlike debt, however, failure to pay the dividend on preferred stock does not set
off bankruptcy.
6.
a.
Under majority voting, the shareholder can cast 90 votes for a favorite
candidate.
b.
Under cumulative voting with 10 candidates, the shareholder can cast
10 x 90 = 900 votes for a favorite candidate.
a.
Under majority voting, each candidate is voted on in a separate election. To
ensure that your candidate is elected, you need to own at least half the
shares, which is 200,000 shares (or 200,001 shares to ensure a strict majority
of the votes).
b.
Under cumulative voting, all candidates will be voted on at once, and there
will be 5 × 400,000 = 2,000,000 votes cast. If your candidate receives onefifth of the votes, he or she will place at least fifth in the balloting and will
be elected to the board. Therefore, you would need to cast 400,000 votes for
your candidate, which would require that you own 80,000 shares.
a.
Common shares will go up by 10 million shares x $55 per share = $550
million. The accounts will appear as follows:
7.
8.
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Copyright © 2006 McGraw-Hill Ryerson Limited
Book value of common stockholders’ equity of George Weston Limited (figures in millions)
Common Shares
$670
Retained Earnings
4,046
Foreign Currency Translation Adjustments
(192)
Net Common Equity
4,524
b. The cost of the share repurchase to George Weston is $60 x 500,000 =
$30,000,000. If the average issue price of these shares is $30, common shares
will be reduced by $30 x 500,000 = $15,000,000. The rest of the reduction is to
retained earnings: $15 x 500,000 = $15,000,000. Common shareholders’ equity is
now arrived at as follows:
(figures in millions)
Common Shares (670 - 15)
$655
Retained Earnings (4,046 - 15)
4,031
Foreign Currency Translation Adjustments
(192)
Net Common Equity
4,494
9.
Lease obligations are like debt in that both legally obligate the firm to make a
series of specified payments. Bondholders would like the firm to limit lease
obligations for the same reason that they desire limits on debt: to keep the firm’s
financial burden at manageable levels and make the already existing debt safer.
10.
a.
A call provision gives the firm a valuable option. It will require the firm to
compensate the investor by promising a higher yield to maturity.
b.
A restriction on further borrowing protects bondholders. They will therefore
require a lower yield to maturity.
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Copyright © 2006 McGraw-Hill Ryerson Limited
c.
Collateral also protects the bondholder and results in a lower yield to
maturity.
d.
The option to convert gives the bondholders a valuable option. They will
therefore be satisfied with a lower promised yield to maturity.
11.
Income bonds are like preferred stock in that the firm promises to make specified
payments to the security holder. If the firm cannot make those payments,
however, the firm is not forced into bankruptcy. The advantage of income bonds
over preferred stock is that the interest payments are tax-deductible expenses.
12.
In general, the fact that preferred stock has lower priority in the event of
bankruptcy reduces its price and increases its yield compared to bonds; on the
other hand, the fact that the dividend payments are free of taxes to corporate
holders increases the price and reduces the yield at which preferred stock trades.
For strong firms, the default premium will be small and the tax effect will
dominate, so the preferred will have a lower yield than the bonds. For weaker
firms the default premium will dominate.
13.
From Alcan’s Annual Report for 2003, we get the following:
Equity
•
•
•
•
14.
Debt (note 19)
•
•
•
•
•
•
Redeemable preference shares.
Common shares.
Contributed surplus.
Retained earning.
Commercial paper.
Debentures
Bank loans
Global notes
Euro medium term notes
Bonds
Bell Canada’s annual report can be accessed through its website at
/>To answer the question, this site was accessed in August, 2005.
• Book value of common equity 2004 – $ 16.781 billion (2004 Annual ReportBalance Sheet).
•
Common shares outstanding for 2003 – 923,988,818 and 2004
-925,935,682 (Note 21 of the 2004 Annual Report)
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Copyright © 2006 McGraw-Hill Ryerson Limited
•
15.
Bell Canada has raised money in a variety of ways, including plowing back
earnings (through an increase in retained earnings) and issuing new common
shares. In 2004, the company raised money through retained earnings (2004 –
increase by $55 million), than through the issue of common shares ($32
million) (See cash flow statement).
Alcan
• Long-term debt-to-equity (Book – in millions of US$)
2002 - 3,196/8,465 =0.38
2003 - 7,604/10,555= 0.72
Note: Equity =common shareholders’ equity.
• Long term debt-to-equity (Market Value) = long-term debt/ (average price per
share x average shares outstanding)
Note:
1.
2.
3.
Average shares outstanding at year end taken from Annual Report (in millions)2003=365.81 and 2002 =321.470 (Note 21)
Average Stock Price 2003 =US$34.53, 2002= US$33.44. For each year,
average stock price was computed as monthly closing prices/12). Monthly
closing price taken from Yahoo Finance.
Market value of equity and long-term debt are quoted in U.S $
2002- Long-term debt (market value) = 3,196/ 10,750 = 0.30
2003- Long-term debt (market value) = 7,604/ 12,610 = 0.60
(Here, the numerator is comprised of the book value of long-term debt).
16.
INCO LTD - For year ending December 31, 2004
USES OF FUNDS
• Capital Expenditure
• Preferred dividends
• Reduction of long term debt
SOURCES OF FUNDS
• Long-term borrowing
• Common preferred shares issued
FALCONBRIDGE LTD-For year ending December 31, 2004
USES OF FUNDS
• Capital investment
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Copyright © 2006 McGraw-Hill Ryerson Limited
• Long term debt reduction
• Dividend paid
SOURCES OF FUNDS
• Long term debt
• Common and preferred shares issued
• Sale of investment
Notice the similarity in the financing patterns of the two companies.
17.
a). Anheuser-Busch’s internal source of funds includes; retained earnings, and
equity issues.
External source – debt financing.
Anheuser-Busch’s primary use of funds during 2001 – 2003 include; capital
expenditure and new business acquisitions. (Cash Flow Statement 2003)
b).
Long-term debt-to-equity (book value -US$million)
• 2003 – 2.69 (7,285.4/2711.7)
• 2002 – 2.16 (6,60.2/3,052.3)
• 2001 – 1.47 (5,983.9/4,061.5)
Long-term debt-to-equity (market value- US$million)
• 2003 – 0.18 (7,285.4/40,695.7)
• 2002 – 0.15 (6,603.2/43,083.5)
• 2001 – 0.16 (5,983.9/37,877.7)
• Long term debt-to-equity (Market Value) = Book value of long-term debt/
(average price per share x average shares outstanding)
Note:
• Monthly closing price taken from Yahoo Finance.
• Average shares outstanding at year end taken from Annual Report(in million) 2003=813.1,
2002=846.6, 2001= 879.1
• Average Stock Price 2003=US$50.05, 2002=US$50.89, 2001= US$43.03( monthly closing
price/12)
• Market value of equity and long-term debt are quoted in U.S $
• Long-term debt/common equity.
Using market value of equity the long-term debt-to-equity has improved
significantly for Anheuser-Busch. This is due to higher market value of equity.
13-6
Copyright © 2006 McGraw-Hill Ryerson Limited
c. i).
For example, Big Rock Brewery’s internal source of financing includes
retained earnings and equity issues. External source of financing – long
term debt.
Big Rock Brewery’s primary use of funds – capital expenditure.
ii).
Long term debt –to- equity (Book - US$ million)
2003 - 1.754/20.65 = 0.085
2002 - 0.941/13.65 = 0.069
2001 - 2.199/12.06 = 0.182
Long term debt-to-equity (market value)
2003 - 1.754/39.47= 0.04
2002 - 0.941/24.95=0.04
2001 - 2.199/24.94=0.09
Note:
• Monthly closing price taken from Yahoo Finance.
• Average shares outstanding at year end taken from Annual Report(in millions) 2003=5.542,
2002=5.242, 2001= 4.909
• Average Stock Price 2003=7.05, 2002=4.76, 2001= 5.08(monthly closing price/12)
• Market value of equity and long-term debt are quoted in U.S $
• Long-term debt/common equity.
Note: Big Rock Brewery’s fiscal year ended in March until 2003 when it
switched to a calendar year. The ratios for 2001 to 2003 use the March
fiscal year-end.
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Copyright © 2006 McGraw-Hill Ryerson Limited
Appendix 13A: Practice Problem Solutions
1.
Before making the bond refunding decision, we calculate the present value of the
net investment cost for E-Books.com by following the steps below:
Call premium = 0.05 x $1,000,000 = $50,000.
The annual tax deduction on flotation cost of new issue = $25,000/5 =
$5,000.
The annual tax savings over 5 years will be 0.25 x $5,000 = $1,250.
After-tax cost of new debt = 9.0% (1- 0.25)
= 6.75%
The present value of the tax savings on the flotation cost is computed by applying
the annuity formula as follows:
1
1 −
5
1.0675
The present value of the tax savings = $1,250 ×
0.0675
= $5,160
The net after-tax flotation cost on the new issue is calculated as follows:
Gross flotation costs on new issue
$ 25,000
Present value of associated tax savings
- 5,160
Net after-tax flotation cost on new issue
$19,840
1
The additional interest cost on the old issue = $1,000,000 × × 0.11 × (1 − 0.25)
12
= $6,875
Since E-Books.com can invest the proceeds from the new issue in the money
market for one month, we consider the after-tax interest E-Books.com would earn.
1
After-tax interest earned = $1,000,000 × × 0.05 × (1 − 0.25)
12
= $3,125
Now, we compute the net after-tax additional interest cost to E-Books.com:
after-tax additional interest paid on the old issue
the after-tax interest earned on the new issue
The net after-tax additional interest cost
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Copyright © 2006 McGraw-Hill Ryerson Limited
$6,875
- 3,125
$3,750
The total present value of the net investments costs associated with the refunding
decision is provided below:
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Copyright © 2006 McGraw-Hill Ryerson Limited
Call premium
Net after-tax flotation cost on new issue
Net after-tax additional interest
Total present value of net investment costs
$50,000
19,840
+ 3,750
$73,590
We consider the net savings from refunding. Therefore, we first compute the
following:
The annual after-tax interest cost on the old issue:
= $1,000,000 x 0.11 x (1- 0.25) = $82,500.
The annual after-tax interest cost on the new issue:
= $1,000,000 x 0.09 x (1-0.25) = $67,500.
The yearly interest saving from going forward with refunding is $82,500 - $67,500
= $15,000. To find the present value of this stream of yearly savings, we, once
again, discount the annuity by the after-tax interest cost of the new issue.
The present value of the net savings from refunding:
1
1 −
5
1.0675
= $15,000 ×
0.0675
= $61,917
Finally, we calculate the net present value from bond refunding.
PV of net savings over 5 years
PV of net investment cost
NPV of bond refunding
$61,917
- 73,590
($11,673)
Since NPV is negative, E-Books.com should not refund the bond issue.
Rate Time period Dollar amount ($)
(years)
Outstanding bond issue
Coupon interest rate on old issue
0
1,000,000
0
1,000,000
11%
New bond issue
Coupon interest rate on new issue
9.0%
After-tax coupon interest rate on new issue
6.8%
Short-term investment yield per annum
5.0%
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Copyright © 2006 McGraw-Hill Ryerson Limited
Rate Time period Dollar amount ($)
(years)
Marginal tax rate
25%
Present Value of Net Investment Costs
Call premium on outstanding bond issue
5%
0
50,000
Rate Time period Dollar amount ($)
(years)
0
25,000
Flotation cost on new issue
Flotation cost amortized for tax purposes
1-5
5,000
Annual tax savings
1-5
1,250
PV of tax savings on flotation costs
0
5,160
Net after-tax flotation cost on new issue
0
19,840
Additional interest cost on old issue
0
6,875
Interest earned on S-T investment of new
issue (after tax)
Net after-tax additional interest
0
3,125
0
3,750
Total PV of after-tax investment costs
0
73,590
Annual after tax interest on old issue
1-5
82,500
Annual after tax interest on new issue
1-5
67,500
Net annual savings in interest cost
1-5
15,000
PV of total interest cost savings over 5 years
0
61,917
Net Present Value (NPV) from bond
refunding
0
-11,673
Net Savings from Refunding
Since the NPV is negative, E-Books.com concludes that it will not be profitable for
the firm to refund the existing bond issue at this time.
2.
We calculate the present value of the net investment cost as follows:
Call premium = 0.07 x $10,000,000 = $700,000.
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Copyright © 2006 McGraw-Hill Ryerson Limited
The annual tax deduction on flotation cost of new issue = $150,000/5 =
$30,000.
The annual tax savings over 5 years will be 0.35 x $30,000 = $10,500.
After-tax cost of new debt = 9.0% (1- 0.35)
= 5.85%
The present value of the tax savings on the flotation cost is computed by applying
the annuity formula as follows:
1
1 −
5
1
.
0585
The present value of the tax savings = $10,500 ×
0.0585
= $44,411
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Copyright © 2006 McGraw-Hill Ryerson Limited
The net after-tax flotation cost on the new issue is calculated as follows:
Gross flotation costs on new issue
$ 150,000
Present value of associated tax savings
- 44,411
Net after-tax flotation cost on new issue
$105,589
The additional interest cost on the old issue:
1
= $10,000,000 × × 0.12 × (1 − 0.35)
12
= $65,000
Since Food-Galore can invest the proceeds from the new issue in the money
market for one month, we consider the after-tax interest E-Books.com would earn.
1
After-tax interest earned = $10,000,000 × × 0.10 × (1 − 0.35)
12
= $54,167
Now, we can calculate the net after-tax additional interest cost to Food-Galore as
follows:
After-tax additional interest paid on the old issue
$65,000
The after-tax interest earned on the new issue
- 54,167
The net after-tax additional interest cost
$10,833
We can now arrive at the total present value of the net investments cost of
refunding.
Call premium
$700,000
Net after-tax flotation cost on new issue
105,589
Net after-tax additional interest
+ 10,833
Total present value of net investment costs
$816,422
Now, we must consider the net savings from refunding. Therefore, we must first
calculate the following:
The annual after-tax interest cost on the old issue = $10,000,000 x 0.12 x (10.35) = $780,000.
The annual after-tax interest cost on the new issue = $10,000,000 x 0.09 x
(1-0.35) = $585,000.
Therefore, the yearly interest saving from going forward with refunding is
$780,000 - $585,000 = $195,000. To find the present value of this stream of yearly
savings, we, once again, discount the annuity by the after-tax interest cost of the
new issue.
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Copyright © 2006 McGraw-Hill Ryerson Limited
The present value of the net savings from refunding:
1
1 −
20
1.0585
= $195,000 ×
0.0585
= $2,264,127
Finally, we calculate the net present value from bond refunding:
PV of net savings over 5 years
PV of net investment cost
NPV of bond refunding
$2,264,127
- 816,422
$1,447,705
Since the NPV is positive, Food-Galore should go forward with the bond
refunding activities.
Rate Time period Dollar amount ($)
(years)
Outstanding bond issue
0
10,000,000
0
10,000,000
0
700,000
0
150,000
Flotation cost amortized for tax purposes
1-5
30,000
Annual tax savings
1-5
10,500
PV of tax savings on flotation cost
0
44,411
Net after-tax flotation cost on new issue
0
105,589
Coupon interest rate on old issue
12%
New bond issue
Coupon interest rate on new issue
9.0%
After-tax coupon interest rate on new issue
5.9%
Short-term investment yield per annum
10%
Marginal tax rate
35%
Present Value of Net Investment Costs
Call premium on outstanding bond issue
7.0%
Flotation cost on new issue
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Copyright © 2006 McGraw-Hill Ryerson Limited
Additional interest cost on old issue
0
65,000
Interest earned on S-T investment of new
issue (after tax)
Net after-tax additional interest
0
54,167
0
10,833
Total PV of after-tax investment costs
0
816,422
Annual after tax interest on old issue
1-20
780,000
Annual after tax interest on new issue
1-20
585,000
Net Savings from Refunding
Rate Time period Dollar amount ($)
(years)
1-20
195,000
Net annual savings in interest cost
PV of total interest cost savings over 20 years
0
2,264,127
Net Present Value (NPV) from bond
refunding
0
1,447,705
Since the NPV is positive, Food Galore Inc. concludes that it will be profitable for
the company to refund the existing bond issue
3.
The present value of the net investment cost is computed as follows:
Call premium = 0.12 x $100,000,000 = $12,000,000.
The annual tax deduction on flotation cost of new issue = $5,000,000/5 =
$1,000,000.
The annual tax savings over 5 years will be 0.35 x $1,000,000 = $350,000.
After-tax cost of new debt = 10% (1- 0.35)
= 6.5%
The present value of the tax savings on the flotation cost is computed as follows:
1
1 −
5
1.065
The present value of the tax savings = $350,000 ×
0.065
= $1,454,488
The net after-tax flotation cost on the new issue is calculated as follows:
Gross flotation costs on new issue
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Copyright © 2006 McGraw-Hill Ryerson Limited
$ 5,000,000
Present value of associated tax savings
Net after-tax flotation cost on new issue
- 1,454,488
$3,545,512
The additional interest cost on the old issue:
1
= $100,000,000 × × 0.14 × (1 − 0.35)
12
= $758,333
Food-Galore can invest the proceeds from the new issue in the money market for
one month. The after-tax interest E-Books.com would earn is:
1
After-tax interest earned = $100,000,000 × × 0.06 × (1 − 0.35)
12
= $325,000
The net after-tax additional interest cost is:
After-tax additional interest paid on the old issue
The after-tax interest earned on the new issue
The net after-tax additional interest cost
$758,333
- 325,000
$433,333
We now arrive at the total present value of the net investments cost of refunding.
Call premium
Net after-tax flotation cost on new issue
Net after-tax additional interest
Total present value of net investment costs
$12,000,000
3,545,512
+ 433,333
$15,978,845
Now, we must consider the net savings from refunding. Therefore, we must first
calculate the following:
The annual after-tax interest cost on the old issue:
= $100,000,000 x 0.14 x (1- 0.35) = $9,100,000.
The annual after-tax interest cost on the new issue:
= $100,000,000 x 0.10 x (1-0.35) = $6,500,000.
Therefore, the yearly interest saving from going forward with refunding is $9.1
million - $6.5 million = $2.6 million. To find the present value of this stream of
yearly savings, we, once again, discount the annuity by the after-tax interest cost
of the new issue.
The present value of the net savings from refunding:
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Copyright © 2006 McGraw-Hill Ryerson Limited
1
1 −
20
1.065
= $2,600,000 ×
0.065
= $28,648,119
Finally, we can now calculate the net present value from bond refunding by
taking the difference between the present value of the net savings and the present
value of the net investment cost.
PV of net savings over 5 years
PV of net investment cost
NPV of bond refunding
$28,648,119
- 15,978,845
$12,669,274
Since the NPV is positive, Universal Heavy Equipment should go forward with the
bond refunding activities at this time.
Rate Time period Dollar amount ($)
(years)
Outstanding bond issue
0
100,000,000
0
100,000,000
0
12,000,000
0
5,000,000
Flotation cost amortized for tax purposes
1-5
1,000,000
Annual tax savings
1-5
350,000
Coupon interest rate on old issue
14%
New bond issue
Coupon interest rate on new issue
10.0%
After-tax coupon interest rate on new issue
6.5%
Short-term investment yield per annum
6.0%
Marginal tax rate
35%
Present Value of Net Investment Costs
Call premium on outstanding bond issue
12%
Flotation cost on new issue
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Copyright © 2006 McGraw-Hill Ryerson Limited
PV of tax savings on flotation cost
0
1,454,488
Net after-tax flotation cost on new issue
0
3,545,512
Additional interest cost on old issue
0
758,333
Interest earned on S-T investment of new
issue (after tax)
Net after-tax additional interest
0
325,000
0
433,333
Total PV of after-tax investment costs
0
15,978,846
Annual after tax interest on old issue
1-20
9,100,000
Annual after tax interest on new issue
1-20
6,500,000
Net annual savings in interest cost
1-20
2,600,000
PV of total interest cost savings over 20 years
0
28,648,119
Net Present Value (NPV) from bond
refunding
0
12,669,273
Net Savings from Refunding
Since the NPV is positive, Universal Heavy Equipment concludes that it will be profitable
for the company to refund the existing bond issue.
Detailed Formula Inserts for the Excel Spreadsheet used in Practice Problem 3.
A
1
2
3
4
5
6
Outstanding bond issue
Coupon interest rate on old issue
New bond issue
Coupon interest rate on new issue
After-tax coupon interest rate on
new issue
B
Rate
C
D
Time period
Dollar amount ($)
(years)
0
100000000
0.14
0
0.1
=B5*(1-B8)
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Copyright © 2006 McGraw-Hill Ryerson Limited
100000000
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
Short-term investment yield per
0.06
annum
Marginal tax rate
0.35
Present Value of Net Investment Costs
Call premium on outstanding bond
0.12
issue
Flotation cost on new issue
Flotation cost amortized for tax
purposes
Annual tax savings
PV of tax savings on flotation cost
Net after-tax flotation cost on new
issue
Additional interest cost on old issue
Interest earned on S-T investment of
new issue (after tax)
Net after-tax additional interest
Total PV of after-tax investment
costs (D10 + D15 + D18)
Net Savings from Refunding
Annual after tax interest on old
issue
Annual after tax interest on new
issue
Net annual savings in interest cost
PV of total interest cost savings
over 20 years
Net Present Value (NPV) from bond refunding
3.
0
=D2*B10
0
1-5
5000000
=D11/5
1-5
0
0
=D12*B8
=D13*(1-(1/(B6+1)^5))/B6
=D11-D14
0
0
=D2*(1/12*B3)*(1-B8)
=D4*(1/12*B7)*(1-B8)
0
0
=D16-D17
=D10+D15+D18
1-20
=D2*B3*(1-B8)
1-20
=D4*B5*(1-B8)
1-20
0
=D21-D22
=D23*(1-(1/
(B6+1)^20))/B6
=D24-D19
0
The present value of the net investment cost with Canada call feature is
computed as follows:
Price of a bond = 140(PVIFA 10%, 20) + {1000/ (1+r) 20
= 140(8.5136) + {1000/ (1.10) 20
= 1191.90 + 148.64
= $ 1,340.54
Call premium per bond = price per bond – par value of bond.
= 1,340.54 – 1000.00
= $ 340.54
Total Call Premium = 340.54 X 100,000 = $ 34,054,000
The annual tax deduction on flotation cost of new issue = $5,000,000/5 =
$1,000,000.
13-19
Copyright © 2006 McGraw-Hill Ryerson Limited
The annual tax savings over 5 years will be 0.35 x $1,000,000 = $350,000.
After-tax cost of new debt = 10% (1- 0.35)
= 6.5%
The present value of the tax savings on the flotation cost is computed as follows:
1
1 −
5
1
.
065
The present value of the tax savings = $350,000 ×
0.065
= $1,454,488
The net after-tax flotation cost on the new issue is calculated as follows:
Gross flotation costs on new issue
Present value of associated tax savings
Net after-tax flotation cost on new issue
$ 5,000,000
- 1,454,488
$3,545,512
The additional interest cost on the old issue:
1
= $100,000,000 × × 0.14 × (1 − 0.35)
12
= $758,333
Food-Galore can invest the proceeds from the new issue in the money market for
one month. The after-tax interest E-Books.com would earn is:
1
After-tax interest earned = $100,000,000 × × 0.06 × (1 − 0.35)
12
= $325,000
The net after-tax additional interest cost is:
After-tax additional interest paid on the old issue
The after-tax interest earned on the new issue
The net after-tax additional interest cost
$758,333
- 325,000
$433,333
We now arrive at the total present value of the net investments cost of refunding.
Call premium
Net after-tax flotation cost on new issue
Net after-tax additional interest
Total present value of net investment costs
$34,054,000
3,545,512
+ 433,333
$38,032,845
Now, we must consider the net savings from refunding. Therefore, we must first
calculate the following:
13-20
Copyright © 2006 McGraw-Hill Ryerson Limited
The annual after-tax interest cost on the old issue:
= $100,000,000 x 0.14 x (1- 0.35) = $9,100,000.
The annual after-tax interest cost on the new issue:
= $100,000,000 x 0.10 x (1-0.35) = $6,500,000.
Therefore, the yearly interest saving from going forward with refunding is $9.1
million - $6.5 million = $2.6 million. To find the present value of this stream of
yearly savings, we, once again, discount the annuity by the after-tax interest cost
of the new issue.
The present value of the net savings from refunding:
1
1 −
20
1.065
= $2,600,000 ×
0.065
= $28,648,119
Finally, we can now calculate the net present value from bond refunding by
taking the difference between the present value of the net savings and the present
value of the net investment cost.
PV of net savings over 5 years
PV of net investment cost
NPV of bond refunding
$28,648,119
- 38,032,845
- $9,384,726
Since the NPV is negative, Universal Heavy Equipment should not go forward
with the bond refunding activities at this time.
A
1
2
3
Outstanding bond issue
Par Value per bond
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Copyright © 2006 McGraw-Hill Ryerson Limited
B
C
Rate
Time period
(years)
0
D
Dollar amount ($)
100,000,000
1,000
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
Coupon interest rate on old issue
New bond issue
Coupon interest rate on new issue
After-tax coupon interest rate on new issue
Short-term money market investment yield
Marginal tax rate
Present Value of Net Investment Costs
Call price per bond
Call premium per bond
Call premium on outstanding bond issue
Flotation cost on new issue
Flotation cost amortized for tax purposes
Annual tax savings on amortized flotation cost
PV of tax savings on flotation cost
Net after-tax flotation cost on new issue
Additional interest cost on old issue
Interest earned on S-T investment of new issue (after tax)
Net after-tax additional interest
Total PV of after-tax investment costs (D13 + D18 + D21)
Net Savings from Refunding
Annual after tax interest on old issue
Annual after tax interest on new issue
Net annual savings in interest cost
PV of total interest cost savings over 15 years
Net Present Value (NPV) from bond refunding (D27- D22)
A
14%
0
10.0%
6.5%
6.0%
35%
1340.54
B
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100,000,000
C
0
1-5
1-5
0
0
0
0
0
0
340.54
34,054,000
5,000,000
1,000,000
350,000
1,454,488
3,545,512
758,333
325,000
433,333
38,032,846
1-20
1-20
1-20
0
0
9,100,000
6,500,000
2,600,000
28,648,119
-9,384,727
D
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
Rate
Outstanding bond issue
Par Value per bond
Coupon interest rate on old issue
New bond issue
Coupon interest rate on new issue
After-tax coupon interest rate on new issue
Short-term money market investment yield
Marginal tax rate
Present Value of Net Investment Costs
Time period
(years)
0
Dollar amount ($)
100000000
1000
0.14
0
100000000
0.1
=B6*(1-B9)
0.06
0.35
Call price per bond
Call premium per bond
Call premium on outstanding bond issue
Flotation cost on new issue
Flotation cost amortized for tax purposes
Annual tax savings on amortized flotation cost
PV of tax savings on flotation cost
Net after-tax flotation cost on new issue
Additional interest cost on old issue
Interest earned on S-T investment of new
issue (after tax)
Net after-tax additional interest
Total PV of after-tax investment costs
(D13 + D18 + D21)
Net Savings from Refunding
Annual after tax interest on old issue
Annual after tax interest on new issue
Net annual savings in interest cost
PV of total interest cost savings over 15 years
Net Present Value (NPV) from bond
refunding (D27 - D22)
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=(B4*D3)*(1-(1/1.1)^20/0.1)
+1000/(1.1)^20
0
1-5
1-5
0
0
0
=D11-D3
=D12*D2/D3
2500000
=D14/5
=D15*B9
=D16*(1-(1/(B7+1)^5))/B7
=D14-D17
=D2*(1/12*B4)*(1-B9)
0
0
=D5*(1/12*B8)*(1-B9)
=D19-D20
0
=D13+D18+D21
1-20
1-20
1-20
0
0
=D2*B4*(1-B9)
=D5*B6*(1-B9)
=D24-D25
=D26*(1-(1/(B7+1)^20))/B7
=D27-D22
