New York Water (NYW) is considering whether to refund a $50 million, 14 percent

Question

    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?

Explanation / Answer

a.

Floatation costs ( Old issue):

Remaining life on old bonds = 25 years

Unexpensed floatation cost = (25/30)($3) = $2,500,000

Tax saving = $2,500,000(Tax rate = 0.4) = -$1,000,000

Cost of call premium = 0.14 * $50,000,000 = $7,000,000

After tax cost of call premium = $7,000,000(0.6) = $4,200,000

Flotation costs on new issue = $3,000,000

Relevant refunding investment outlay =  $4,200,000 + $3,000,000 - $1,000,000 = $6,200,000

b.

Interest on old issue :

$50,000,000(0.14)(0.6) = $4,200,000

Interest on New issue:

$50,000,000(0.1167)(0.6) = (3,501,000)

Net annual interest savings $699,000

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