New York Water (NYW) is considering whether to refund a $50 million, 14 percent
ID: 2635658 • Letter: N
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?
Explanation / Answer
a. Here are the current costs affecting the refunding cash outlay:
The call premium is paid on the par value of the original bond issue: $50 MM * 14% = 7MM
The recognition of the remaining $2,500,000 floatation cost of the original bonds will be accelerated. The immediate tax shield benefit of this acceleration = $2.5 MM * 40% = $1.0 MM. Only the tax shield affect is a current cost, the cash paid at issue of the bond is a sunk cost.
The Floatation cost of the new bonds is $3.0 MM.
Total refunding outlay: $7.0 MM - $1.0 MM + $3.0 MM = $9.0 MM
b. The original interest payments were $7.0 MM annually. The new interest payments are $5.835 MM The annual savings is $1.165 MM.
c. The annual tax effect due to the refunding is the tax effect of the change in amortized floatation costs. $3.0 MM straight line amortized over 25 years is $120,000 per year versus $100,000 per year for the original bond