Chapter 12-Web Appendix 12B Solutions

Chapter 12-Web Appendix 12B Solutions - WebAppendix12B...

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Web Appendix 12B Refunding Operations Answers to Questions 12B-1 The decision to refund a security is analyzed in much the same way as a capital budgeting  expenditure.  The costs of refunding (the investment outlays) are (1) the call premium paid for the  privilege of calling the old issue, (2) the costs of selling the new issue, (3) the tax savings from  writing off the unexpensed flotation costs on the old issue, and (4) the net interest that must be paid  while both issues are outstanding (the new issue is often sold prior to the refunding to ensure that  the funds will be available).  The annual cash flows, in a capital budgeting sense, are the interest  payments that are saved each year plus the net tax savings that the firm receives for amortizing the  flotation expenses.  The net present value method is used to analyze the advantages of refunding:  the future cash flows are discounted back to the present, and then this discounted value is  compared with the cash outlays associated with the refunding.  The firm should refund the bond  only if the present value of the savings exceeds the cost—that is, if the NPV of the refunding  operation is positive. 12B-2 In the discounting process, the after-tax cost of the new debt, r d , should be used as the discount  rate.  The reason is that there is relatively little risk to the savings—cash flows in a refunding  decision are known with relative certainty, which is quite unlike the situation with cash flows in most  capital budgeting decisions. 12B-3 Although a refunding analysis shows that the refunding would increase the firm’s value, the  question still remains whether refunding at this time would truly maximize the firm’s expected value.  If interest rates continue to fall, the company might be better off waiting, for this could increase the  NPV of the refunding operation even more.  The mechanics of calculating the NPV in a refunding  are easy, but the decision of when to refund is not simple at all because it requires a forecast of  future interest rates.  Thus, the final decision on refunding now versus waiting for a possibly more 
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