Chapter 18, Problem 6P

a)

Summary Introduction

To determine: The total dollar call premium required to call the old issue, whether it is tax deductible and the net after-tax cost of the call.

Explanation of Solution

The overall premium is $0.11\left(\$40,000,000\right)=\$4,400,000$, since the call premium is 11 per cent. This is a tax deductible expense, though, so the actual after-tax expense is $\$4,400,000\left(1-T\right)=\$4,400,000\left(1-0.4\right)=\$2,640,000$.

b)

Summary Introduction

To determine: The dollar floatation cost and whether it is immediately tax deductible and post-tax flotation cost.

Explanation of Solution

On the new issue the currency flotation rate is $0.04\left(\$40,000,000\right)=\$1,600,000$. The expense is not tax-deductible immediately and therefore the after-tax payment is $1,600,000, too. (Note that the flotation costs may be prorated and charged over the lifetime of the issue. The value of this tax savings shall be computed in Part e.).

c)

Summary Introduction

To determine: The amounts of old issue floatation cost and not been expensed and whether these deferred costs be expensed immediately if the old issue is refunded and the value of tax savings.

Explanation of Solution

On the old issue the flotation costs were $0.06\left(\$40,000,000\right)=\$2,400,000$. These costs have been postponed and are expensed over the issue's 25-year life, and thus $\frac{\$2,400,000}{25}=\$96,000$ is spent annually, or $48,000 every 6 months. If the question is reimbursed, the unexpended part of the cost of the flotation can be expended immediately, resulting in tax savings of $\text{T}\left(\$1,920,000\right)=0.40\left(\$1,920,000\right)=\$768,000$.

d)

Summary Introduction

To determine: The net post-tax cash outlay needed to refund the old issue.

Explanation of Solution

e)

Summary Introduction

To determine: The semiannual tax savings that arises from amortizing the floatation cost and the foregone semiannual tax savings on the old-issue floatation cost.

Explanation of Solution

The $1,600,000 cost of new issue flotation would be depreciated over the issue's 20-year existence. Therefore, it would cost $\frac{\$1,600,000}{20}=\$80,000$ every year, or $40,000 every six months. The tax savings from this tax deduction are $\left(0.40\times \$40,000\right)=\$16,000$ per half-year. By reimbursing the old issue and spending the surviving old issue flotation costs instantly, the company forgoes the opportunity to continue spending on the old flotation costs over time. In total, $\frac{\$2,400,000}{25}=\$96,000$ annually, or $48,000 semi-annually. The forgone value for every $48,000 deduction is $0.40\left(\$48,000\right)=\$19,200$.

f)

Summary Introduction

To determine: The semiannually post-tax interest savings that would result from the refunding.

Explanation of Solution

The interest on the old issue is $0.11\left(\$40,000,000\right)=\$4,400,000$ per annum, or $2,200,000 per term. Since interest payments are tax deductible the semi-annual after-tax balance is $0.6\left(\$2,200,000\right)=\$1,320,000$. The new issue bears a coupon rate of 8 percent. The annual interest would therefore be $0.08\left(\$40,000,000\right)=\$3,200,000$, or $1,600,000 semi-annually. Therefore the after-tax cost is $0.6\left(\$1,600,000\right)=\$960,000$. Thus, after-tax net interest savings would be $1,320,000 or $960,000 = $360,000 semi-annually if reimbursement takes place.

g)

Summary Introduction

To determine: The sum of these two semiannual cash flows and appropriate discount rate to apply to these two semiannual cash flows and the present value.

Explanation of Solution

The estimated amortization tax benefits over 20 years are about $3,200 per year, while the net interest costs over 20 years are about $360,000 per year. The net semi-annual cash balance, as shown below, is thus $356,800.

The cash flows are predicated on treaty obligations and therefore have about the same level of risk as to the debt of the company. In fact, the cash flows are already tax-net. Consequently, the suitable interest rate is the after-tax cost of debt to GST.(The citation of the cash to fund the net investment expenditure also affects the discount rate, but most companies use debt to finance that expenditure, and in this case, the discount rate should be the after-tax debt cost.)Finally, as we are valuing future flows, the correct debt cost is the cost of today, or the cost of the new issue, and not the debt cost that floated five years ago. The appropriate rate of discount is thus 0.6(8 percent) = 4.8 percent per annum, or 2.4 percent per semi-annual period.

h)

Summary Introduction

To determine: The NPV of refunding and whether the GST refund now or wait until later.

Explanation of Solution

The redemption of bonds would entail a net cash outlay of $3,472,000, but on a present-value basis it would yield $9,109,413 in net savings. The refunding NPV is thus $5,637,413:

The choice to repay instead of wait until later is much harder than finding the refunding NPV now. If interest rates were expected to fall, and therefore GST could issue debt below today's 8 percent rate in the future, then it might pay to wait. Interest rate motions, however, are very difficult to predict, if not impossible, and thus most financial managers would likely take the "bird-in - the-hand" and reimburse with such a large NPV now. Remember, however, that if the NPV were quite low, say $1,000, management would certainly have been waiting, hoping interest rates would fall lower, and waiting costs ($1,000) wouldn't have been large enough to think about.