Case 048Liability management and refinancingCore

Brahmila Cement's Rs 500 crore 10% bond is callable at 101 with four years left. It can issue new four-year bonds at 8.2% with issue costs of 0.5%. What is the net present value of calling and refinancing?

The situation

Brahmila Cement issued Rs 500 crore of bonds at 10% when rates were higher. The bonds have four years left and are callable today at 101, a Rs 5 crore premium over face. Its bankers say it could issue new four-year bonds at 8.2%, with arranger fees and other costs of 0.5% of the issue, Rs 2.5 crore.

The treasurer asks whether to call now. Ignore tax for the main answer, assume annual coupons, and discount at the new bond's rate.

Your task

Work out the net present value of calling and refinancing, the new coupon at which it stops paying, and anything that would change the answer.

Quick check

Roughly what is the net present value of calling now?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Calling is worth about Rs 22.2 crore today. The coupon falls from 10% to 8.2%, saving Rs 9 crore a year for four years, worth Rs 29.7 crore at 8.2%. Against that Brahmila pays a Rs 5 crore call premium and Rs 2.5 crore of issue costs. The call keeps paying until the new coupon reaches about 9.5%, so there is a wide margin for pricing to move before launch.

Step 1What is the refinancing decision, in plain terms?

A family with a home loan at 10% is offered 8.2% elsewhere, with a prepayment charge and a processing fee. It switches if the interest saved, counted in today's money, beats the charges. Calling a bond pays when the present value of the coupon saving exceeds the call premiumThe amount above face value an issuer must pay to redeem a bond early, set in the bond terms. plus the cost of the new issue. Brahmila pays Rs 7.5 crore today to save Rs 9 crore a year for four years.

Step 2What is the saving worth today?

Discount each Rs 9 crore at the new rate. Rs 9 crore a year for four years at 8.2% is worth Rs 29.68 crore today, so the net present value of calling is Rs 29.68 crore less Rs 7.5 crore, about Rs 22.2 crore. Discounting at the new bond's rate is the standard shortcut because the saving is as certain as Brahmila's own debt service. On an after-tax basis, with interest, premium and costs deductible at 25% and the saving discounted at the after-tax rate, the value is about Rs 17.7 crore, still clearly positive; confirm the tax treatment of the premium and costs.

Pay Rs 7.5 crore now to save Rs 9 crore a year for four yearstoday-7.5premium 5 + costs 2.5+9.0PV 8.32year 1+9.0PV 7.69year 2+9.0PV 7.10year 3+9.0PV 6.57year 4PV of savings 29.7 - 7.5NPV = +22.2Rs crore. Dashed: saving as paid. Green: its value today at 8.2%.
Brahmila pays Rs 7.5 crore today in call premium and costs and saves Rs 9 crore a year for four years, worth Rs 29.7 crore at 8.2%, a net present value of about Rs 22.2 crore.
The relationship
NPV=9×1−1.082−40.082−5−2.5=29.68−7.5≈22.2\text{NPV} = 9 \times \frac{1 - 1.082^{-4}}{0.082} - 5 - 2.5 = 29.68 - 7.5 \approx 22.2
9coupon saved each year: 1.8% on Rs 500 crore
5call premium, 1% of face
2.5issue costs, 0.5% of the new bond
What it says in wordsThe value of calling is the discounted saving less what must be paid today to get it.
Step 3How much room is there, and what would change the answer?

Solve for the new coupon at which the call only breaks even. At about 9.53% the saving no longer covers Rs 7.5 crore, so the market can move almost 130 basis points against Brahmila before the refinancing stops paying. Two refinements belong in the answer. If the new bond settles before the old one is redeemed, Brahmila pays both coupons for the overlap, about Rs 1.6 crore for a month net of interest earned on the proceeds. And calling now gives up the option to call later at a lower rate, though each year of waiting forfeits Rs 9 crore of saving.

Calling pays until the new coupon reaches about 9.5%-200+20+407.5%8.0%8.5%9.0%9.5%10.0%Coupon on the new 4-year bond8.2%: +22.2breakeven 9.53%old coupon 10%
The net present value of calling is Rs 22.2 crore at a new coupon of 8.2% and falls to zero at about 9.53%, so the refinancing tolerates a large move in rates before launch.

Where candidates lose it

The common slip is adding up the savings without discounting: four times Rs 9 crore is Rs 36 crore, which overstates the gain by more than a quarter.

The second is forgetting one of the two costs paid today. Candidates remember the call premium and drop the new issue's costs, or the reverse; both are cash out on day one.

What the interviewer asks next

  • What is the NPV if the call price were 103?
  • Should Brahmila call now or wait a year if it expects rates to fall another 50 basis points?
  • How would you hedge the new coupon between announcing the call and pricing the new bond?

Company names and figures are illustrative.