Problem 15-17 Comparison of private and public debt offering [LO1] The Landers C
ID: 2655442 • Letter: P
Question
Problem 15-17 Comparison of private and public debt offering [LO1]
The Landers Corporation needs to raise $1.80 million of debt on a 20-year issue. If it places the bonds privately, the interest rate will be 10 percent. Forty thousand dollars in out-of-pocket costs will be incurred. For a public issue, the interest rate will be 10 percent, and the underwriting spread will be 5 percent. There will be $90,000 in out-of-pocket costs. Assume interest on the debt is paid semiannually, and the debt will be outstanding for the full 20-year period, at which time it will be repaid. Use Appendix B and Appendix Dfor an approximate answer but calculate your final answer using the formula and financial calculator methods.
For each plan, compare the net amount of funds initially available—inflow—to the present value of future payments of interest and principal to determine net present value. Assume the stated discount rate is 16 percent annually. Use 8.00 percent semiannually throughout the analysis. (Disregard taxes.)(Assume the $1.80 million needed includes the underwriting costs. Input your present value of future payments answers as negative values. Do not round intermediate calculations and round your answers to 2 decimal places.)
Public issue
The Landers Corporation needs to raise $1.80 million of debt on a 20-year issue. If it places the bonds privately, the interest rate will be 10 percent. Forty thousand dollars in out-of-pocket costs will be incurred. For a public issue, the interest rate will be 10 percent, and the underwriting spread will be 5 percent. There will be $90,000 in out-of-pocket costs. Assume interest on the debt is paid semiannually, and the debt will be outstanding for the full 20-year period, at which time it will be repaid. Use Appendix B and Appendix Dfor an approximate answer but calculate your final answer using the formula and financial calculator methods.
Explanation / Answer
In this problem company has to issue $1.80 million debt to mature after 20 years. Interest rate is 10% payable semi-annually. It can be issued in two different manner. They are:
1. Private placement and
2. Public issue.
In case of private placement out of pocket cost of issue is $40,000. For public issue this figure will be $90,000. Also in public issue there will be underwriting spread of 5%. It is the difference between amount received from public and amount payable to company by underwriter.
Therefore in private placement total amount received will be $1.80 million. As out of pocket expense is $40,000, company should issue total debt of $1,800,000+$40,000=$1,840,000. From this after spending pocket expense exactly $1.8 million will be left.
In public issue $1.80 million includes underwriting expenses. But out of pocket cost is not included. Hence add $90,000 with $1.8 million. thus initial value of bond required to be issued is $1,800,000+$90,000 = $1,890,000. From this company has to pay underwriting spread of 5%. Thus net amount available to the company initially will be 95% of bond issue value. It is $1,890,000 x 0.95 = $1,795,500.
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Calculation of present value of outflows in 20 years in private placement will be interest at 10% per annum. as it is paid semi annually, theefore payment of interest after every six month will be:
$1,840,000 x 5% = $92,000.Therefore present value of cash outflows will be
$92,000 x [Present value of annuity of $1 for 40 periods at 4%]+$1,840,000 x [Present value of $1 after 40 periods at 4%]
=$92,000x [19.793 ]+ $1,840,000 x [0.208]
=$1,820,956+$382,720
=$2,203,676
It is the total present value of cash outflows in coming periods. Deduct initial receipt of $1.8 million from this amount to get net present value. The amount is:
$2,203,676 - $1,800,000 = $403,676
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Now consider present value in case of public issue. Now company has to issue $1,890,000 amount of debt. Interest semi annually at 5% will be
$1,890,000 x 5% = $94,500. On maturity $1,890,000 of debt will be returned. Therefore total present value of cash outflows in coming 40 semi annual period at 4% discount rate is:
=$94,500 x [ Present value of $1 annuity for 40 periods at 4%] +$1,890,000 x [ present value of $1 for 40 periods at 4%]
=$94,500 x 19.793 + $1,890,000 x 0.208
=$1,870,438.5+$393,120
=$2,263,558.5
It is total present value of cash flow. Deduct initial net receipt of $1,795,500 from it to get net present value:
=$2,263,558.5 - $1,795,500 = $468,058.5
Answer:
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Answer (b):
From above results it can be concluded that public issue will provide higher net present value.
Details Private placement Public issue Initial net amount $382,720 $393,120 Present value of future payments $2,203,673 $2,263,558.5 Net present value $403,673 $468,058.5