Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

non-cash charge, the amortisation of the

flotation cost results in an annual tax savings of

$5,400 (0.30 × $18,000).

Table 14.4 summarises these calculations. Combining

the first three values [(a), (b) and (c)] yields the

annual after-tax debt payment for the old bond of

$3,131,000. When the values for the new bond [(d)

and (e)] are combined, the annual after-tax debt

payment for the new bond is $2,444,600.

TABLE 14.4 FINDING THE ANNUAL CASH FLOW SAVINGS FOR THE DAVIS COMPANY’S BOND

REFUNDING DECISION

Old bond

a Interest cost

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

b Tax savings from amortisation of discount

[($1,500,000 ÷ 30) × 0.30] (15,000)

c Tax savings from amortisation of flotation cost

[($400,000 ÷ 30) × 0.30] (4,000)

(1) Annual after-tax debt payment $3,131,000

New bond

d Interest cost

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 Tax savings from amortisation of flotation cost

[($450,000 ÷ 25) × 0.30] (5,400)

(2) Annual after-tax debt payment $2,444,600

Annual cash flow savings [(1) – (2)] $ 686,400

Subtracting the new bond’s annual after-tax debt

payment from that of the old bond, we find that

implementation of the proposed bond refunding

will result in an annual cash flow savings of $686,400

($3,131,000 – $2,444,600).

Step 3 Find the net present value (NPV).

Table 14.5 shows the calculations for determining

the NPV of the proposed bond refunding. The

present value of the annual cash flow savings of

$686,400 at the 4.9% after-tax cost of debt over

25 years is computed (using Equation 3.7 on

page 90) to be $9,771,792. Subtracting the initial

investment of $3,650,000 from the present value

of the annual cash flow savings results in a NPV of

$6,121,792. Because a positive NPV results, the

proposed bond refunding is recommended.

Decision: The proposed refunding is

recommended because the NPV of refunding of

$6,121,792 is greater than $0.

example