A B C D E F G H I

4 REFUNDING OPERATIONS (Section 20.9)

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6 This example examines the issue of replacing existing debt with newly issued debt. First, is it profitable to call an
7 outstanding issue and replace it with a new issue? Second, even if refunding now is profitable, would the firm's
8 expected value be further increased if the refunding were postponed until a later date?
9
10 The firm should refund only if the present value of the savings exceeds the cost of the refunding. The after-tax
11 cost of debt should be used as the discount 'rate, since there is relative certainty to the cash flows to be received.
12 Using the example laid out in the chapter, we 'will now evaluate such a scenario.
13
14 Figure 20-1
15 Input Data (in thousands of dollars)
16
17 Existing bond issue = $60,000 New bond issue = $60,000
18 Original flotation cost = $3,000 New flotation cost = $2,650
19 Maturity of original debt = 25 New bond maturity = 20
20 Years since old debt issue = 5 New cost of debt = 9.0%
21 Call premium (%) = 10.0%
22 Original coupon rate = 12.0% Tax rate = 40.0%
23 After-tax cost of new debt = 5.4% Short-term interest rate = 6.0%
24
25 Schedule of cash flows
26 Before-tax After-tax
27 Investment Outlay
28 Call premium on the old bond ($6,000.0) ($3,600.0)
29 Flotation costs on new issue ($2,650.0) ($2,650.0)
30 Immediate tax savings on old flotation cost expense $2,400.0 $960.0
31 Extra interest paid on old issue ($600.0) ($360.0)
32 Interest earned on short-term investment $300.0 $180.0
33 Total after-tax investment ($5,470.0)
34
35 Annual Flotation Cost Tax Effects: t = 1 to 20
36 Annual tax savings from new-issue flotation costs $132.5 $53.0
37 Annual lost tax savings from old-issue flotation costs ($120.0) ($48.0)
38 Net flotation cost tax savings $12.5 $5.0
39
40 Annual Interest Savings Due to Refunding: t = 1 to 20
41 Interest on old bond $7,200.0 $4,320.0
42 Interest on new bond ($5,400.0) ($3,240.0)
43 Net interest savings $1,800.0 $1,080.0
44
45 Calculating the annual flotation cost tax effects and the annual interest savings
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47 Annual Flotation Cost Tax Effects Annual Interest Savings
48 Maturity of the new bond (Nper) 20 Maturity of the new bond (Nper) 20
49 After-tax cost of new debt (Rate) 5.4% After-tax cost of new debt (Rate) 5.4%
50 Annual flotation cost tax savings (Pmt) $5 Annual interest savings (Pmt) $1,080
51
52
Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they represent
53 annuities. To evaluate this project, we must find the present values of these savings. Using the function wizard
and solving for present value, we find that the present values of these annuities are:
54
55
56 NPV of annual flotation cost savings $60.251 NPV of annual interest savings $13,014.174
57
58 Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the present
59 values of the annual flotation cost tax effects and interest savings.
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61 Bond Refunding NPV = Initial Outlay + PV of flotation costs + PV of interest savings
62 Bond Refunding NPV = ($5,470.000) + $60.251 + $13,014.174
63
64 Bond Refund NPV = $7,604.425
65
66
67 Our refunding analysis tells us that should the firm proceed with the bond refunding, the project will
68 have a positive net present value. However, unlike traditional capital budgeting decisions, the
69 positive NPV does not tell the firm if 'it should refund the bond issue. That decision is dependent
70 upon several external factors, including interest rate expectations.
71
72 Scenario Analysis
73
74
75
76
Rates fall Rates stay the same Rates go up
77 Probability 25% 50% 25%
78 Rate 7% 9% 11%
79 NPV of
refunding $17,947.071 $7,390.083 ($1,359.939)
80
81
82 Expected
NPV $8,181.809
 A B C D E F G H I
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 A B C D E F G H I
4 This worksheet contains a model to analyze a rights offering.
5
6 Model for Evaluating A Rights Offering
7
8 Southeast Airlines currently has 1 million shares of stock selling for $100 per share. It plans to raise $10 million
9 in new equity through a rights offering that will allow holders of the rights to purchase the new share of stock at
10 $80 per share. Each stockholder will get 1 right for each share of stock that they own.
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12 Funds to be raised= $10,000,000
13 Subscription price= $80
14 Number of old shares= 1,000,000
15 Old price per share= $100
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17
18 Number of new shares Funds to be raised ÷ Subscription price
19 Number of new shares 125,000
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21 Number of rights needed to buy a share of new stock = Old shares / New shares
22 Number of rights needed to buy a share of new stoc 8
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24 New total market value of equity = Old total market value + New funds raised
25 New total market value of equity = $110,000,000
26 New total number of shares = 1,125,000
27 New price per share = $97.78
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30 Value of One Right
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32 Value of one right = Market value of stock, rights on - Subscription price
33 Number of rights required to buy one share of stock + 1
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35 Value of one right = 20 = $2.22
36 9
37 Alternatively:
38 Value of one right = Market value of stock, ex rights - Subscription price
39 Number of rights required to buy one share of stock
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41 Value of one right = 18 = $2.22
42 8
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44 Effects on the Wealth of Stockholders
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46 Assume a stockholder has 8 shares of stock.
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48 Wealth before rights announcement = Number of shares x Price per share
49 Wealth before rights announcement 8 x $100 = $800

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 A B C D E F G H I
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51 Wealth if stockholder exercises the right
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53 Cost to purchase the right = $80.00
54 Number of shares after exercising the right = 9
55 Price per share after rights offering = $97.78
56 Wealth after exercising the right = Number of shares x Price per share
57 Wealth after exercising the right = $880.00
58 Change in wealth = Ending wealth - starting wealth - cost to exercise right
59 Change in wealth = $880.00 - $800.00 - $80.00
60 Change in wealth = $0.00
61
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63 Wealth if stockholder sells the right
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65 Value of right = $2.22
66 Proceeds from selling the rights = Number of rights x Value of right
67 Proceeds from selling the rights = 8x $2.22 = $17.78
68 Number of shares after selling the right = 8
69 Price per share after rights offering = $97.78
70 Wealth after selling the right = Number of shares x Price per share
71 Wealth after selling the right = $782.22
72 Change in wealth = Ending wealth - starting wealth + proceeds from selling the right
73 Change in wealth = $782.22 - $800.00 + $17.78
74 Change in wealth = $0.00

Page 7
SECTION 20.3
SOLUTIONS TO SELF-TEST

A company is planning an IPO. Its underwriters have said the stock will sell at $50 per share. The
underwriters will charge a 7% spread. How many shares must the company sell to net $93 million, ignoring
any other expenses?

Price = $50
Spread = 7%
Target proceeds = $93 million

Net price = $46.50

Required number of shares = $2.0000 million

hare. The
93 million, ignoring