Question

Jan Volk, financial manager of Green Sea Transport (GST), has been asked by her
boss to review GST’s outstanding debt issues for possible bond refunding. Five years
ago, GST issued $40,000,000 of 11%, 25-year debt. The issue, with semiannual cou-
pons, is currently callable at a premium of 11%, or $110 for each $1,000 par value
bond. Flotation costs on this issue were 6%, or $2,400,000.
Volk believes that GST could issue 20-year debt today with a coupon rate of 8%.
The firm has placed many issues in the capital markets during the last 10 years, and
its debt flotation costs are currently estimated to be 4% of the issue’s value. GST’s
federal-plus-state tax rate is 40%.
Help Volk conduct the refunding analysis by answering the following questions.
a. What is the total dollar call premium required to call the old issue? Is it tax de-
ductible? What is the net after-tax cost of the call?
b. What is the dollar flotation cost on the new issue? Is it immediately tax deduct-
ible? What is the after-tax flotation cost?
c. What amounts of old-issue flotation costs have not been expensed? Can these
deferred costs be expensed immediately if the old issue is refunded? What is the
value of the tax savings?
d. What is the net after-tax cash outlay required to refund the old issue?
Chapter 20: Initial Public Offerings, Investment Banking, and Financial Restructuring 821
e. What is the semiannual tax savings that arises from amortizing the flotation costs
on the new issue? What is the forgone semiannual tax savings on the old-issue
flotation costs?
f. What is the semiannual after-tax interest savings that would result from the
refunding?
g. Thus far, Volk has identified two future cash flows: (1) the net of new-issue flo-
tation cost tax savings and old-issue flotation cost tax savings that are lost if re-
funding occurs and (2) after-tax interest savings. What is the sum of these two
semiannual cash flows? What is the appropriate discount rate to apply to these
future cash flows? What is their present value?
h. What is the NPV of refunding? Should GST refund now or wait until later?

Answer 1