A B C D E F G H

39 18-9 Refunding Operations

40
41 This example examines the issue of replacing existing debt with newly issued debt. First, is it profitable to call an
42 outstanding issue and replace it with a new issue? Second, even if refunding now is profitable, would the firm's expected
43 value be further increased if the refunding were postponed until a later date?
44
45 The firm should refund only if the present value of the savings exceeds the cost of the refunding. The after-tax cost of
46 debt should be used as the discount 'rate, since there is relative certainty to the cash flows to be received. Using the
47 example laid out in the chapter, we 'will now evaluate such a scenario.
48
49 Figure 18-1
50 Spreadsheet for the Bond Refunding Decision (Thousands of Dollars)
51 Input Data
52 Existing bond issue = $60,000 New bond issue = $60,000
53 Original flotation cost = $3,000 New flotation cost = $2,650
54 Maturity of original debt = 25 New bond maturity = 20
55 Years since old debt issue = 5 New cost of debt = 9.0%
56 Call premium (%) = 10.0%
57 Original coupon rate = 12.0% Tax rate = 40.0%
58 After-tax cost of new debt = 5.4% Short-term interest rate = 6.0%
59 Investment Outlay Before-tax After-tax
60 Call premium on the old bond −$6,000 −$3,600
61 Flotation costs on new issue −$2,650 −$2,650
62 Immediate tax savings on old flotation cost expense $2,400 $960
63 Extra interest paid on old issue −$600 −$360
64 Interest earned on short-term investment $300 $180
65 Total after-tax investment −$5,470
66
67 Annual Flotation Cost Tax Effects: t = 1 to 20 Before-tax After-tax
68 Annual tax savings from new-issue flotation costs $132.5 $53.0
69 Annual lost tax savings from old-issue flotation costs −$120.0 −$48.0
70 Net flotation cost tax savings $12.5 $5.0
71
72 Annual Interest Savings Due to Refunding: t = 1 to 20 Before-tax After-tax
73 Interest on old bond $7,200 $4,320
74 Interest on new bond −$5,400 −$3,240
75 Net interest savings $1,800 $1,080
76
77 Annual Flotation Cost Tax Effects Annual Interest Savings
78 Annual flotation cost tax savings (Pmt) $5 Annual interest savings (Pmt) $1,080
79 Maturity of the new bond (Nper) 20 Maturity of the new bond (Nper) 20
80 After-tax cost of new debt (Rate) 5.4% After-tax cost of new debt (Rate) 5.4%
81 NPV of annual flotation cost savings $60 NPV of annual interest savings $13,014
82
83 Total Net Present Value of the Refunding
84 Bond Refunding NPV = Initial outlay + PV of flotation costs + PV of interest savings
85 Bond Refunding NPV = −$5,470 + $60 + $13,014
86
87 Bond Refund NPV = $7,604
88
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 A B C D E F G H
90 Our refunding analysis tells us that should the firm proceed with the bond refunding, the project will have
91 a positive net present value. However, unlike traditional capital budgeting decisions, the positive NPV does
92 not tell the firm if 'it should refund the bond issue. That decision is dependent upon several external
factors, including interest rate expectations.
93
94
95 Scenario Analysis
96
97
98
99
Rates fall Rates stay the same Rates go up
100 Probability 25% 50% 25%
101 Rate 7% 9% 11%

102 NPV of
refunding $17,947.071 $7,390.083 ($1,359.939)
103
104
105 Expected NPV $8,181.809
106
107
 I
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bt. First, is it profitable41
to call an
w is profitable, would the 42firm's expected
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of the refunding. The 45 after-tax cost of
cash flows to be received. 46 Using the
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81 Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they represent
82 annuities. To evaluate this project, we must find the present values of these savings.
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84 Hence, the net present value of this bond refunding project will be the sum of the initial outlay
85 and the present values of the annual flotation cost tax effects and interest savings.
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 A B C D E F G H
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55 6 9.0%
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 A B C D E F G H
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55 6 7.0%
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 A B C D E F G H
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55 5 9.0%
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 A B C D E F G H
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55 6 11.0%
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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 in new equity
9 through a rights offering that will allow holders of the rights to purchase the new share of stock at $80 per share. Each
10 stockholder will get 1 right for each share of stock that they own.
11
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
16
17
18 Number of new shares= Funds to be raised ÷ Subscription price
19 Number of new shares= 125,000
20
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 stock = 8
23
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
28
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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
40
41 Value of one right = 18 = $2.22
42 8
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44 Effects on the Wealth of Stockholders
45
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

Page 8
 A B C D E F G H I
50
51 Wealth if stockholder exercises the right
52
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
62
63 Wealth if stockholder sells the right
64
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 9
SECTION 18-3
SOLUTIONS TO SELF-TEST

A privately held company has an estimated value of equity equal to $100 million. The founders own 10 million
shares. If they sell 1 million shares with no underwriting costs, how much should the per share offer price be?
($10.00) If instead the underwriting spread is 7%, what should the offer price be? ($9.93)

Estimated value of the firm's equity before the IPO = $100.00 million
Number of shares before the IPO = 10.00 million
Number of new shares sold in the IPO = 1.00 million

Percentage spread = 0%
Offer price = (VPre-IPO)/[(F nNew) + nExisting]
Offer price = $10.00

Percentage spread = 7%

Offer price = $9.93

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