Bond Repurchase Case In January 2019, Dick and Jane were two new financial analysts at Acme Corporation. They were asked by management to evaluate whether there were savings to be had, and value created, by making a tender offer for an outstanding bond, and financing the purchase with a new bond, issued at current market rates. Interest rates had come down since the outstanding bond was issued, and some managers felt that by refinancing ( through the tender and new issue) they could generate interest savings. However, the outstanding bond does not have a call feature, nor a make whole feature, so the only way to redeem the bond was to either tender for it or make open market purchases. Either way, the company would have to pay a premium over par (face) value of the outstanding bond in order to induce investors to sell to the company. The bond in question was issued, at par, on February 1, 2017, and matures on February 1, 2027. Management wants the transaction to settle on February 1 since it's an interest payment date. The details of the outstanding bond, and the new bond, are as given below. Note: In order to leave the maturity schedule unchanged after the tender of the outstanding bond, management was seeking to do a matched maturity refunding (i.e., issue a new bond with the same maturity and payment dates as the outstanding bond). Settlement Date of repurchase and new issue Maturity Date of Outstanding Bond and New Bond Tax Rate Outstanding Bond Face (Outstanding Bond) Coupon (Outstanding Bond) Remaining Life in Years (Outstanding Bond) Current Market Yield @ 8 years Current Market Price (Outstanding Bond) Modified Duration (Outstanding Bond New Bond Face (New Bond) Coupon (New Bond) Term of New Bond in Years Current Market Yield @ 8 years Current Market Value (New Bond) Modified Duration 2/1/2019 1/1/2027 35.000% $ 1,000.00 5.000% 8 3.500% $1,103.88 7.99 $1,103.88 3.500% 8 3.500% $1,033.28 8.38 Jane noted that the outstanding bond had a coupon rate of 5.00%, the coupon rate on the new bond would be lower at 3.50%, and that 3.5% was the current market yield to maturity for the outstanding bond, and is also the yield that their bankers say would be required on the new bond (would you expect this to be the case?). Jane claimed that if the company bought the outstanding bond at a premium (its current market price is above par) that reflects the present value of the difference between the interest rate of 5.0% on the outstanding bond and both a coupon rate (and market yield of 3.5%) on the new bond, that by financing the purchase with the sale of a new bond of identical credit risk and terms other than the coupon rate, market yield and par amount, there could be no savings. Dick said he was told by the tax department that any premium over par that was paid to repurchase the outstanding bond would be considered a tax-deductible expense in the year of the repurchase. He thought that the deduction of the premium might be the source of the savings management was hoping for. In response, Jane noted that by repurchasing the outstanding bond, the company was giving up a tax shield evaluated at a 5.0% coupon rate in exchange for a tax shield generated at only a 3.5% coupon rate, so there would still be a tax shield "shortfall." She also noted that there would be a need to issue $1,103.88 par amount (face or principal amount) of new bonds for each $1,000 of par amount of the outstanding bond, making the base for calculating interest expense larger, while also increasing the final amount that would have to be paid at maturity. At this point neither were sure whether the repurchase would result in a gain, loss, or breakeven situation, but in any event, it would depend on the tax deductibility of the new interest expense and the repurchase premium paid in the tender. Your job is to help Dick and Jane "spot" the essential elements in the refinancing issue, quantify the gain or loss (if any), make a recommendation to management, and produce a spreadsheet showing your work along with an explanation of what you did to support your recommendation. For simplicity, in our analysis we are going to ignore all the issuance expenses associated with both the outstanding and the new bonds. Bond Repurchase Case In January 2019, Dick and Jane were two new financial analysts at Acme Corporation. They were asked by management to evaluate whether there were savings to be had, and value created, by making a tender offer for an outstanding bond, and financing the purchase with a new bond, issued at current market rates. Interest rates had come down since the outstanding bond was issued, and some managers felt that by refinancing ( through the tender and new issue) they could generate interest savings. However, the outstanding bond does not have a call feature, nor a make whole feature, so the only way to redeem the bond was to either tender for it or make open market purchases. Either way, the company would have to pay a premium over par (face) value of the outstanding bond in order to induce investors to sell to the company. The bond in question was issued, at par, on February 1, 2017, and matures on February 1, 2027. Management wants the transaction to settle on February 1 since it's an interest payment date. The details of the outstanding bond, and the new bond, are as given below. Note: In order to leave the maturity schedule unchanged after the tender of the outstanding bond, management was seeking to do a matched maturity refunding (i.e., issue a new bond with the same maturity and payment dates as the outstanding bond). Settlement Date of repurchase and new issue Maturity Date of Outstanding Bond and New Bond Tax Rate Outstanding Bond Face (Outstanding Bond) Coupon (Outstanding Bond) Remaining Life in Years (Outstanding Bond) Current Market Yield @ 8 years Current Market Price (Outstanding Bond) Modified Duration (Outstanding Bond New Bond Face (New Bond) Coupon (New Bond) Term of New Bond in Years Current Market Yield @ 8 years Current Market Value (New Bond) Modified Duration 2/1/2019 1/1/2027 35.000% $ 1,000.00 5.000% 8 3.500% $1,103.88 7.99 $1,103.88 3.500% 8 3.500% $1,033.28 8.38 Jane noted that the outstanding bond had a coupon rate of 5.00%, the coupon rate on the new bond would be lower at 3.50%, and that 3.5% was the current market yield to maturity for the outstanding bond, and is also the yield that their bankers say would be required on the new bond (would you expect this to be the case?). Jane claimed that if the company bought the outstanding bond at a premium (its current market price is above par) that reflects the present value of the difference between the interest rate of 5.0% on the outstanding bond and both a coupon rate (and market yield of 3.5%) on the new bond, that by financing the purchase with the sale of a new bond of identical credit risk and terms other than the coupon rate, market yield and par amount, there could be no savings. Dick said he was told by the tax department that any premium over par that was paid to repurchase the outstanding bond would be considered a tax-deductible expense in the year of the repurchase. He thought that the deduction of the premium might be the source of the savings management was hoping for. In response, Jane noted that by repurchasing the outstanding bond, the company was giving up a tax shield evaluated at a 5.0% coupon rate in exchange for a tax shield generated at only a 3.5% coupon rate, so there would still be a tax shield "shortfall." She also noted that there would be a need to issue $1,103.88 par amount (face or principal amount) of new bonds for each $1,000 of par amount of the outstanding bond, making the base for calculating interest expense larger, while also increasing the final amount that would have to be paid at maturity. At this point neither were sure whether the repurchase would result in a gain, loss, or breakeven situation, but in any event, it would depend on the tax deductibility of the new interest expense and the repurchase premium paid in the tender. Your job is to help Dick and Jane "spot" the essential elements in the refinancing issue, quantify the gain or loss (if any), make a recommendation to management, and produce a spreadsheet showing your work along with an explanation of what you did to support your recommendation. For simplicity, in our analysis we are going to ignore all the issuance expenses associated with both the outstanding and the new bonds