Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

Call Premiums

The amount by which the call price exceeds the face value of the bond is the call premium. It is paid by the

issuer to the bondholder to buy back outstanding bonds prior to maturity. The call premium is treated as

a tax-deductible expense in the year of the call.

Bond Discounts and Premiums

When bonds are sold at a discount or at a premium, the company is required to amortise (write off) the

discount or premium in equal portions over the life of the bond. The amortised discount is treated as a

tax-deductible expenditure, whereas the amortised premium is treated as taxable income. If a bond is

retired prior to maturity, any unamortised portion of a discount or premium is deducted from or added

to pretax income at that time.

example

The Davis Company, a manufacturer of industrial

piping, is contemplating calling $50 million of 30-

year, $1,000 face value bonds (50,000 bonds) issued

five years ago with a coupon interest rate of 9%. The

bonds have a call price of $1,090, and initially netted

proceeds of $48.5 million due to a discount of $30

per bond (50,000 bonds × $970 net per bond). The

initial flotation cost was $400,000. The company

intends to sell $50 million of 25-year, $1,000 face

value bonds with a 7% (coupon) interest rate to raise

funds for retiring the old bonds. The flotation costs

on the new issue are estimated to be $450,000. The

company is currently in the 30% tax bracket, and

estimates its after-tax cost of debt to be 4.9% [0.07 ×

(1 – 0.30)]. Because the new bonds must first be

sold, and their proceeds then used to retire the old

bonds, the company expects a two-month period of

overlapping interest, during which interest must be

paid on both the old and the new bonds.

Step 1 Find the initial investment. Finding

the initial investment requires a number of

calculations.

a Call premium. The call premium per bond is

$90 ($1,090 call price – $1,000 face value).

Because the total call premium is deductible

in the year of the call, its after-tax cost is

calculated as follows:

Before tax ($90,350,000 bonds) $4,500,000

Less: Taxes (0.30 3 $4,500,000) $1,350,000

After-tax cost of call premium $3,150,000

b Flotation cost of new bond. This cost was

given as $450,000.

c Overlapping interest.^3 The after-tax cost of

the overlapping interest on the old bond is

treated as part of the initial investment and

calculated as follows:

Before tax [0.09 3 (2 ÷ 12) 3 $50,000,000] $750,000

Less: Tax shield (0.30 3 $750,000) $225,000

After-tax cost of overlapping interest $525,000

d Unamortised discount on old bond. The

company was amortising the $15,00,000

discount ($50,000,000 face value –

$48,500,000 net proceeds from sale) on the

old bond over 30 years. Because only five

of the 30 years’ amortisation of the discount

have been applied, the company can deduct

the remaining 25 years of unamortised

discount as a lump sum, thereby reducing

taxes by $375,000 [(25 ÷ 30) × $1,500,000 ×

0.30].

e Unamortised flotation cost of old bond.

The company was amortising the $400,000

initial flotation cost on the old bond over

30 years. Because only five of the 30

years’ amortisation of this cost have been

applied, the company can deduct the

remaining 25 years of unamortised flotation

call premium
The amount by which the
call price exceeds the face
value of a bond. Paid by
corporations to buy back
outstanding bonds prior to
maturity

3 Technically, the after-tax amount of overlapping interest could be reduced by the after-tax interest earnings from investment of the average

proceeds available from the sale of the new bonds during the interest overlap period. To simplify, we ignore any interest earned on the

proceeds from sale of the new bonds during the overlap period.