FN2 Ron Muller 2007-08

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MODULE 3: LONG-TERM SOURCES OF FUNDS

QUESTION 1

TM Corp. has $10,000,000 bond issue outstanding, with annual interest payments at 12%. The issue has 15 years remaining until maturity, but it is callable now with a call premium equal to one years interest. Call premiums are not deductible for tax purposes. A new bond issue at an interest cost of only 6% can now be raised, with 15 years to maturity and annual interest payments. Flotation costs of $500,000 would be incurred. In order to be sure of having the needed financing, TM would issue the new bonds 1 month prior to calling the current bond issue. Extra funds from the new issue can be invested in short-term securities at an annual rate of 4%, for the 1-month overlap period. Flotation costs are deductible for tax purposes over a 5-year period. Assume a 40% corporate tax rate. Required: Should TM pursue the bond refinancing opportunity? Explain your reasoning and provide supporting calculations.

FN2 Ron Muller 2007-08

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QUESTION 1 SOLUTION

Appropriate discount rate = after tax borrowing rate = 6 (1 - .4) = 3.6% Call premium: 10,000,000 x .12 ( 1,200,000) Flotation costs ( 500,000) After tax interest expense on the old issue: 10,000,000 x .12 x 1/12 (1 - .4) ( 60,000) After tax interest earned on funds invested: (10,000,000 x .04) (1 - .4) x 1/12 + 20,000

( 1,740,000) PV of tax savings on flotation costs: + 180,092 Pmt = 40,000 n = 5 FV = 0 i = 3.6% PV = ? = 180,092 PV of after tax interest savings: + 4,116,935 Pmt = 360,000 n = 15 FV = 0 i = 3.6% PV = ? = 4,116,935 NPV of refunding + 2,557,027 CONCLUSION: Since the NPV is positive, go for it!

FN2 Ron Muller 2007-08

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QUESTION 2

AG Corp. has an outstanding $5,000,000 of preferred shares, with a $50 face value per share and $1.25 per share of quarterly dividends. The call premium on this issue is 5%, and it would cost $750,000 to float a new preferred share issue. A new issue would pay only $1.00 per share per quarter in dividends. If preferred shares are refinanced, AG would issue the new preferred shares 2 months prior to calling the outstanding issue. During the overlap period, extra funds from the new issue can be invested in short-term securities at an annual rate of 4.25%, and dividends continue to accrue on the existing issue of preferred shares. Flotation costs are deductible for tax purposes over a 5-year period. Assume a 40% corporate tax rate. Required: Should AG pursue the preferred share refinancing opportunity? Explain your reasoning and provide supporting calculations.

FN2 Ron Muller 2007-08

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QUESTION 2 SOLUTION

Appropriate discount rate = cost of new preferred share financing IF, you can get $1.00 for every $50 you own per quarter, isnt that like getting a $1.00 of income? So what is the rate? It is equal to: 1/50 = 2%. BUT, that 2% is a quarterly rate. When you are calculating the PV of the annual dividend savings, you need a quarterly rate so use that 2%. When you are calculating the PV of the tax savings on flotation costs, you need an annual rate, so you must determine the annual rate. The nominal rate is: 2% x 4 = 8%. From the formula sheet, EAR = (1 + knom/m)

m - 1 = (1 + .08/4)4 - 1 = (1 + .02)4 - 1 = 1.0824322 - 1 = 8.24% Cost of calling: .05 x 5,000,000 ( 250,000) Flotation costs ( 750,000) PV of tax savings on flotation costs: + 238,055 Pmt = 60,000 n = 5 FV = 0 i = 8.24% PV = ? = 238,055 After tax overlap interest received: 5,000,000 x .0425 x 2/12 (1 - .4) + 21,250 Overlap dividends paid: 5,000,000/50 x 1.25 x 2/3 ( 83,333)

( 824,028) + PV of annual dividend savings (treat as a perpetual) 100,000 shares x (1.25 - 1.00) = 25,000 : as a perpetual: 25,000/.02 your quarterly rate + 1,250,000 NPV + 425,972 Since NPV is positive, the refinancing should be pursued.