The Springfield Gas and Electric Company is considering refunding $50 million of

Question

The Springfield Gas and Electric Company is considering refunding $50 million of 11 percent debt with an 8 percent, 20-year debt issue. The existing, or old, issue also matures in 20 years and now is callable at 108 percent of par. The unamortized issuance cost on the old issue is $400,000, and the issuance cost of the new issue is 0.875 percent. The company estimates that both issues will be outstanding for four weeks, resulting in overlapping interest. The company has a weighted cost of capital of 10 percent and a 40 percent marginal tax rate. In addition, the company

Explanation / Answer

To determine whether Springfield Gas and Electric Company(SGEC) should refund the old issue,a bond refunding analysis is carried out. Step 1:Calculate the interest savings (cash inflows). Annual interest,after-tax = Issue size*Interest rate*(1 – Tax rate) Annual interest,old issue = $50 million*11%*0.6 = $3.30 million Annual interest,new issue = $50 million*8%*0.6 = $2.40 million Annual after-tax interest savings= $0.90 million PV of interest savings = Annual after-tax interest savings*PVIFA0.06,20 = $0.9 million*11.4699= $10.323million ...........................(G) Step 2:Calculate the net investment (net cash outflow at time 0). This involves computing the after-tax call premium,the issuance cost of the new issue,the issuance costofthe old issue,and the overlapping interest. The after-tax call premium is calculated as follows: 1.08*$50M - 50M = 4M Call premium,after-tax = Call premium*(1 – Tax rate) = $4 million*(1 – 0.4)= $2.40 million ................(a) The call premium is a cash outflow The issuance cost on the new issue is 0.875 percent,or 0.875*$50M = $437,500. This amount cannot be deducted from SGEC’s current period income for tax purposes.Instead,it must be capitalized and amortized over the life of the debt issue because the benefits that accrue to a firm as a result of an insuance cost expenditure occur over the life ofthe issue. Thus,PV of issuance cost of new issue =Issuance cost – PV tax effect =Issuance cost –(Annual After Tax savings from amortization *PVIFA0.06,20) ie Issuance cost=Issuance cost –(Issuance cost/No of Yrs)*Tax Rate*PVIFA0.06,20 = $437,500 –($437,500/20)*(40%)*11.4699 =$437,500 – $100,362 = $337,138 ..................(b) The present value of the issuance cost of the new issue is a net cash outflow SGEC has been amortizing the issuance cost ofthe old issue over its life.Ifit refunded the issue,the company would no longer receive the benefits from the old issue’s issuance cost and therefore could write offthe remaining unamortized issuance cost at the time of refunding.Because ofthe write-off,however,SGEC would lose the benefits of the old issuance cost over the remaining life of the issue.Thus, PV of issuance cost of Old issue = PV of Lost Benefits, Old issuance cost after tax - PV of Writee off Old issuance cost after Tax = (Old Issuance cost/No of Yrs)*Tax rate*PVIFA0.06,20 – (Old issuance cost*Tax rate) = ($400,000/20)*40%*11.4699 - ($400,000*40%) = $(68,241) ...................(c) The issuance cost effect of the old issue is a net cash inflow at the time of refunding.In most bond refundings,it is necessary for a firm to sell the new issue and receive the proceeds before paying off the old lenders.Both issues are usually outstanding for less than a month.Thus,the interest expense on the old issue during the overlapping period is considered a cost,or part of the refunding investment.In SGEC’s case,this expense is calculated as follows: Overlapping Int = Size of issue * Annual Int Rate of Old issue after tax * Fraction of year both issue outstanding =$50 million*11%*(1-40%)*4/52 = $253,846 ..............(d) The overlapping interest is a cash outflow. In summary,the net investment is calculated as follows: Call premium $2,400,000 PV of issuance cost,new issue 337,138 PV of issuance cost,old issue –68,241 Overlapping interest 253,846 ------------------------------------ Net investment (cash outflow) $2,922,744 ...............(e) Step 3:Finally,calculate the net present value of refunding. NPV of Refunding = PV Int Savings - PV Net Investment = G-e =$10.323 million– $2,922,744 = $7,400,256 Because the net present value is positive,SGEC should call its old issue and refund it with the new one

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