Mr. Cga Essay

762 words - 4 pages

Titan Corporation of Canada (TCC) is based in Ontario. It has a callable outstanding bond issue, which was issued five years ago at a coupon rate of 6%, with a face value of $100 million, and with 20 years remaining to the maturity date. Interest rates at the time of the issue were considerably higher than they are now, and the company would now like to refinance the bonds. TCC’s investment banker assures the CFO that the bonds could now be issued for a 20-year maturity at a coupon rate of 4.5%. The following table shows the characteristics of the outstanding issue of bonds and the planned bond issue.
Old bonds New bonds
Face value $100,000,000 $100,000,000
Remaining maturity 20 years 20 years
Overlap period 2 months 2 months
Coupon rate 6% paid semi-annually 4.5% paid semi-annually
Call premium/flotation costs 50% of coupon rate 2.5% of face value
The new bonds would be issued two months before the old bonds could be called, at a call premium of ...view middle of the document...


Flotation cost=2.5%*100,000,000=$2,500,000

These flotation costs are tax-deductible over five years. Annual tax savings is:
2,500,000/5*0.35 =$175,000
The after-tax effective annual rate of new debt is:
[(1+0.045/2)^2 -1]*(1-0.35) = 2.96%

PV of the future tax savings from the flotation costs is:
PV=175,000* PVIFA (5, 2.96%)=$802,365
Net flotation costs: 2,500,000-802,365=1,697,635

The net additional expense during the overlap period of 2 months on an after-tax basis is: 100,000,000*[(0.06-0.03)/12]*2*(1-0.35)=325,000

Net investment= call premium + net flotation cost + net additional interst expense during the overlap period
=3,000,000+1,697,635+325,000=$ 5,022,635

The incremental after-tax interest saving from refinancing:
Semi-annual interest on the old issue=100,000,000*(0.06/2)*(1-0.35)=1,950,000
Semi-annual interest on the new issue=100,000,000*(0.045/2)*(1-0.35)=1,462,500
Incremental semi-annual after-tax interest savings=1950000-1462500=487,500

Semi-annual after-tax cost of new debt = (1 + 0.0296)^1/2 – 1 = 1.47%
The semi-annual interest savings extend over 40 periods (20 × 2). Discounted at the 3.1286% after-tax cost of the new issue, the present value of semi-annual interest savings= $487,500 × PVIFA(1.47%, 40)= $14,664,154
The present value of interest savings minus the net investment for refinancing
= $14,664,154 – $5,022,635
= $9,641,519
Given that the present value of the interest savings higher than the present value of the refinancing costs, TCC should go ahead with its refinancing plans.

Coupon payment=1000*0.06/2=$30
Periods to maturity=20*2=40
The after-tax effective annual rate of old debt=[(1+0.06/2)^2 -1]*(1-0.35) = 3.96%
Semi-annual after-tax cost of old debt=(1 + 0.0396)^1/2 – 1=1.96%
PV= 30 PVIFA(1.96%, 40) + 1000 PVIF(1.96%, 40)=826.45+460.05=1286.50
$1286.50 should be the current market value per $1,000 face value of the old bonds in the absence of the call provision
c) Call premium at 1000= 1000*0.5*0.06=$30
256.5/2*0.47=241.11 loss
When the market price is 1286.50 and the call price is 1030, an investor will have $241.11 after tax capital loss.

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