Reference no: EM131783780
Assignment: Advanced Corporate Finance
Case Study 3: Refinancing Long-term Debt
Hillary Drumpf was concerned about the effect that high interest expenses were having on the bottom-line reported profits of OnalipacCompuNet Co. Since joining the company three years ago as vice-president of finance, she noticed that operating profits appeared to be improving each year, but that earnings after interest and taxes were declining because of high interest charges.
Because interest rates had finally started declining after a steady increase, she thought it was time to consider the possibility of refunding a bond issue. As she explained to her boss, Ross Allen, refunding meant calling in a bond that had been issued at a high interest rate and replacing it with a new bond that was similar in most respects, but carried a lower interest rate. Bond refunding was only feasible in a period of declining interest rates. Ross Allen, who had been the CEO of the company for the last seven years, understood the general concept, but he still had some questions.
He said to Hillary, "If interest rates are going down, bond prices are certain to be going up. Won't that make it quite expensive to buy in outstanding issues so that we can replace them with new issues?" Hillary had a quick and direct answer. "No, and the reason is that the old issues have a call provision associated with them." A call provision allows the firm to call in bonds at slightly over par (usually 8 to 10% above par) regardless of what the market price is.
Hillary thought if she could present a specific example to Ross he would have a better feel for the bond refunding process. She proposed to call in an 11.50% $30,000,000 issue that was scheduled to mature in the year 2030. The bonds had been issued in 2010, and since it was now 2015 the bonds had 15 years remaining to maturity. It was Hillary's intent to replace the bonds with a new $30,000,000 issue that would have the same maturity date 15 years into the future as that of the original 2010 issue. Based on advice from the firm's investment firm, Seymour Financial Services (SFS), the bonds could be issued at a rate of 10%. Mark Seymour, a senior partner in the investment firm, SFS, further indicated that the underwriting cost on the new issue would be 2.8% of the $30,000,000 amount involved.
Before she could do her analysis, Hillary needed to accumulate information on the old 11.50% bond issue that she was proposing to refund. The original bond indenture indicated that the bonds had an 8% call premium, and that the bonds could be called any time after five years. Hillary explained to Ross Allen that the bondholders were protected from having their bonds called in for the first five years after issue, but that the bonds were fair game after that.
Furthermore, from the sixth through the 13th year, the call premium went down by 1% per year. By the 14th year after issue, there was no call premium and the corporation could merely call in the bonds at par. Since in this case five years had passed, the call premium would be exactly 8%. Hillary checked with the chief accountant and found out that the underwriting cost on the old issue had initially been $400,000. The firm was currently paying taxes at a rate of 30%. There is no overlap time period between "call-in" the old bonds and issue new bonds.
Outline the considerations in whether or not to refund this bond issue with NPV analysis. What must Hillary present to Ross Allen? Will Hillary achieve her original objective? Should Hillary and Ross consider whether interest rates will go even lower? If so, what should they do?