Introduction to Corporate Finance

14: Long-Term Debt and Leasing

cost as a lump sum, thereby reducing taxes
by $100,000 [(25 ÷ 30) × $400,000 × 0.30].
Summarising these calculations in Table 14.3, we
find the initial investment to be $3,650,000. This
means that the Davis Corporation must pay out
$3,650,000 now to implement the proposed bond
refunding.
Step 2 Find the annual cash flow savings. Finding
the annual cash flow savings requires a number
of calculations.

a Interest cost of old bond. The after-tax annual

interest of the old bond is calculated as

follows:

Before tax (0.09 × $50,000,000) $4,500,000

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

After-tax interest cost $3,150,000

TABLE 14.3 FINDING THE INITIAL INVESTMENT FOR THE DAVIS COMPANY’S BOND REFUNDING DECISION

a Call premium

Before tax [($1,090 – $1,000) × 50,000 bonds] $4,500,000

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

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

b Flotation cost of new bond 450,000

c Overlapping interest

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

Less: Taxes (0.30 × $750,000) (225,000)

After-tax cost of overlapping interest 525,000

d Tax savings from unamortised discount on old bond

[(25 ÷ 30) × ($50,000,000 – $48,500,000) × 0.30] (375,000)

e Tax savings from unamortised flotation cost of old bond

[(25 ÷ 30) × $400,000 × 0.30] (100,000)

Initial investment $3,650,000

b Amortisation of discount on old bond. The

company was amortising the $1,500,000

discount ($50,000,000 face value – $48,500,000

net proceeds from sale) on the old bond over

30 years, resulting in an annual write-off of

$50,000 ($1,500,000 ÷ 30). Because it is a tax-

deductible non-cash charge, the amortisation of

this discount results in an annual tax savings of

$15,000 (0.30 × $50,000).

c Amortisation of flotation cost on old bond.

The company was amortising the $400,000

flotation cost on the old bond over 30

years, resulting in an annual write-off of

$13,333 ($400,000 ÷ 30).

Because it is a tax-deductible non-cash

charge, the amortisation of the flotation

cost results in an annual tax saving of

$4,000

(0.30 × $13,333).

d Interest cost of new bond. The after-tax

annual interest cost of the new bond is

calculated as follows:

Before tax (0.07 × $50,000,000) $3,500,000

Less: Taxes (0.30 × $3,500,000) $1,050,000

After-tax interest cost $2,450,000

e Amortisation of flotation cost on the new

bond. The company will amortise the $450,000

flotation cost on the new bond over 25 years,

resulting in an annual write-off of $18,000

($450,000 ÷ 25). Because it is a tax-deductible

example