New Bond will be
issued at the place of old bond.
When
bonds/debentures are redeemed before maturity then the redemption will be at
premium. Premium paid on redemption of bond is called call premium.
Premium on
redemption (Call Premium) will expenses for company i.e. outflow for the
company and it saves tax (Tax Shield on Call Premium Paid) i.e. Inflow for the
company.
Steps for
Calculation of Net Present Value (NPV)
A) Initial
Incremental Cash out Flow
Redemption of Old
Bond XXX
Issue of New Bond (XXX)
Call Premium on
Redemption XXX
New Floatation Cost
XXX
Tax Shield on Call
Premium (XXX)
Tax Shield on
Unamortized floatation Cost Written off on Old Bond (XXX)
Initial
Incremental Cash Outflow XXX
B) Incremental
Annual Cash Inflow
i) Net Saving on
Interest Payments
Interest on Old
Bond XXX
Interest on New
Bond (XXX)
Saving in Interest
XXX
Less: - Tax on Saving in Interest (XXX)
Net Saving in
Interest XXX
ii) Incremental
Tax Shield on Floatation Cost
Tax Shield on New
Floatation Written off XXX
Tax Shield on old
Floatation Written off (XXX)
Initial
Incremental Tax Shield on Floatation Cost XXX
Net Annual
Incremental Cash Inflow i)
+ii)
C) Incremental
Terminal Value (Cash Outflow)
Redemption of New
Bond after Maturity XXX
Redemption of old
Bond after Maturity (XXX)
Net Incremental
Terminal Value (Cash Outflow) XXX
D) NPV
Present Value of
Cash Inflows XXX
Present Value of Cash
Outflows (XXX)
NPV XXX
Decision: -
If NPV is
Positive then replace the existing bond with New Bond.
If NPV is
Negative then do not replace the existing bond with New Bond.
Explanation to
Floating Cost on Issue and Discount on Issue: -
Let us understand
with an example
Example: - ABC
Company has Following Details: -
Revenue Rs. 1000000
Floating Cost (Old
Bond) Rs. 400000 will
be written off for 10 Years.
Floating Cost (New
Bond) Rs. 600000 will be written off for 10
Years.
Other Expenses Rs.
500000
Tax Rate 50% Ignore Cess and Surcharge for
Understanding Purpose
Solution:-
Situation I: - Company doesn’t have floatation
Cost to Written off
Situation II: - Company has floatation Cost on
old Bond to Written off
Situation III: -
Company issued
new bond in place of old bond, it means new floatation Cost to Written off in
Place of old Floatation cost
Particulars
|
Situation I
(Amount in
Rs.)
|
Situation II
(Amount in
Rs.)
|
Situation III
(Amount in
Rs.)
|
Revenue
Expenses
Floatation Cost
on old Bond
Floatation Cost
on new Bond
Taxable Income
Tax
|
1000000
500000
-
-
500000
250000
|
1000000
500000
40000
-
460000
230000
|
1000000
500000
-
60000
440000
220000
|
Conclusion: - By Comparing Situation I
& II we conclude Floatation Cost written off Saves Tax (Tax Shield) which
is treated as Inflow, Tax Shield = Flotation Cost * Tax Rate.
By Comparing
Situation II & III we conclude Floatation Cost Written off on New Bond will
saves but Floatation Cost Not Written off on Old Bond will Increase Tax
Expenses for Company it means Incremental Tax Saving (Tax Shield) will equal to
Tax Saving on Incremental Floatation Cost Written off. Hence, Incremental Tax
Shield (Incremental Inflow) = (Floatation Cost Written Off on New Bond
–Floatation Cost Written Off on Old Bond)*Tax Rate.
Note: - Same
treatment will be done in case of Discount on Issue of Bond/debenture.
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