Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Safari loam Limited issued a Sh.100 million par value, 10-year bond, five years ago. The bond was issued at a 2 per cent discount and issuing costs amounted to Sh.2 million. Due to the decline in Treasury bill rates in the recent past, interest rates in the money market have been falling presenting favorable opportunities for refinancing. A financial analyst engaged the company to assess the possibility of refinancing the debt

reports that a new Sh.100 million par value, 12 per cent, 5 -year bond can be issued the company. Issuing costs for the new bond will be 5 per cent of the par value and a discount of 3 per cent will have to be given to attract investors. The old bond can be redeemed at 10 per cent premium and in addition, two months interest penalty will have to be paid on redemption. All bond issue expenses (including the interest penalty) are a mortised on a straight-line basis over the life of the bond and are allowable for corporate tax purposes.

The applicable corporate tax rate is 40 per cent and the after tax cost of debt to the company is approximately 7%.

Required:
a) Cash investment required for the refinancing decision.
b) Annual cash benefits (savings) of the refinancing decision.
c) i) Net Present Value (NPV) of the refinancing decision.
ii) Is it worthwhile to issue a new bond to replace the existing bond? Explain.
ANSWER
a) Workings
Discount an old bond = 2% x 100M = 2M Issue costs of old bond = Sh.2M
Discount on new bond = 3% x 100M = Sh.3M Issue costs of new bond = 5% x 100M = Sh.5M Call premium = 10% x 100M = Sh.10 M
Overlap interest charges = 16% x 100M x 2/12 = Sh.2.666,667 Remaining maturity period of old bond = 5 years

Initial Capital Investment

a)   Annual cash benefits

New bond

Old Bondi)Net Present ValUE

ii) Its not worthwhile to issue the new bond since the NPV is negative.

 

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