Norman Cahill financial vice president of Seminole Gas and Electric is reviewed the minutes of the meeting of the firm’s board of director. The major topic discussed was whether Seminole should refund a $500 million issued of 26 year, 16 percentage, and mortgage bonds issued in 11 months earlier. Three of the board member has taken markedly different positions. The bond has been issued the previous October, when interest rates were at their peak. At that time , Cahill and the board of director thought that interest rates were at a high and would likely decline in the future , but they had no idea that the slump would come so soon and be so sharp. Now, less than a year later, ...view middle of the document...
Dykeman argued that calling the bonds for refunding would not be well received by the major financial institutions that hold the firm’s outstanding bonds. He pointed out that no utility, at least within his memory span, had called a bond issue in less than three year. According to Dykeman the institutional investor that hold the bonds had purchased them on the expectation of receiving the 16 percentage interest rate for at least three years and these investors would be very much disturbed by a cell after only one year.
Second, Dennis Ryan, a relatively new member of the board and president of a local bank, also opposed the call but for an entirely different reasons. Ryan believed that the decline in interest rates was not yet over. He stated that a study by his bank suggested that the long term interest rate might fall as low as 10 percentage within the next six month.
Thirdly, Scott Kearney, president of a management consulting firm specializing in utility operation stated that he was not opposed in principle to refunding operation, but questioned whether the proposed refunding would be profitable in view of:
1) the very high call premium that would be incurred
2) flotation cost on the refunding issue
3) the firm’s14.5 percentage overall average cost of capital
Kearney suggested that a formal analysis using discount cash flow technique be employed to determine the feasibility of the refunding.
Issue 1: Determine the initial investment outlay required to undertake refunding.
Call premium is 10%
Tax rate (t) is 40%
Amount of old issue is $500 million
Floatation cost on new issue is 0.5% - 1% but throughout this case 0.5%is taken as the floatation cost.
Old interest rate is 16%
New interest rate is 12.50%
Calculation of Call Premium:
Call premium on old issue = Issue amount* Call premium
Before tax: $500 million*0.1= $50 million
Call premium on old issue = Issue amount* Call premium*(1-t)
After tax: $50 (1-0.4) = $30 million
Although the company must spend $ 50 million on the call premium that is a deductible expense in the year the call is made. Because the company is in the 40% tax bracket, it saves $ 20 million in taxes; therefore the after tax cost of the call is only $ 30 million.
Calculation of Floatation Cost:
Flotation cost on old issue = unamortized flotation cost* tax rate
Old issue = 2625000*0.4 = $1.05 million
Flotation cost in new issue = Issue amount * flotation cost percent
New issue = $500 million * 0.5% = $2.5 million
Flotation costs on the new issue will be $2.5 million. This amount cannot be expressed for the tax purposes, so it provides no immediate tax benefit.
Calculation of additional interest expenses:
= Old issue*Old interest rate *(overlapping weeks/ Total weeks in a year)*(1-t)
Before tax= $500million* 3/52*0.16= $4615384.615
After tax= $4615384.615 (1-0.40) = $2.76923 million
Three weeks extra interest on the old issue, after taxes, costs $2.76923...