One year ago XYZ Inc., issued $100 million of 11-year bonds with a 9% coupon, payable annually. The first coupon payment has just been paid. The bonds are callable at 103 beginning today. Floatation costs on that issue were $1 million. Copest has a 34% marginal tax rate.
Since interest rates have fallen, XYZ is considering calling in the bonds and refinancing at current rates. It has two, ten-year, financing alternatives.
1) A $100 million public issue of 8% annual coupon bon<;is. Flotation costs would be $1 million.
2) An 8%, $100 million private placement with semi-annual coupons. There would be a front-end placement fee of $250,000.
Note: Call premiums and interest payments are tax deductible. However, front-end fees and floatation costs must be capitalized and amortized over the life of the bond.
a) Calculate the effective cost of raising funds from the public bond issue. Use the IRR
procedure for all your calculations.
b) Calculate the effective cost of raising funds from the private placement of debt.
c) If XYZ Inc does call in the bonds, which of the two refinancing alternatives is preferable?
d) What is the effective, after-tax cost of leaving the existing bonds in place?
In other words, what would be the after-tax all-in cost of refinancing that would make XYZ Inc indifferent between calling the bonds and leaving them in place?
e) Should XYZ Inc call in the bonds?