Case 053Liability management and refinancingCore

A steel company with surplus cash can buy back its expensive bonds at a premium through a tender offer. Is paying 104 for 9.5% bonds worth it when the cash earns 7%?

The situation

Hiranyak Steel has Rs 800 crore of 9.5% bonds maturing in exactly three years, paying annual coupons. They trade at 103. The company also holds surplus cash that it does not need for operations, currently earning 7% in deposits.

Its bankers propose a tender offer: Hiranyak offers to buy the bonds back at 104, a price that includes an early tender premium for holders who tender in the first ten days. Assume every holder tenders, taxes treat coupon paid and interest earned alike, and 7% is the right rate at which to discount Hiranyak's own cash flows.

Your task

Is the tender worth doing, what is the gain or loss in rupees, and what could change the answer?

Quick check

Paying 4 over par to save 2.5% a year for three years: which is right?

Worked solution

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

30-second answerThe answer to give first

Tender: paying 104 retires a liability worth about 106.56 to Hiranyak at a 7% rate, a gain of about Rs 20.5 crore if every holder tenders. The Rs 32 crore premium buys three years of coupon at 9.5% instead of earning 7% on the cash, worth Rs 52.5 crore today. The gain shrinks if the cash is needed as a buffer or if fewer holders tender.

Step 1What is the company really trading?

Imagine you have a personal loan at 9.5% and savings earning 7%. Your lender lets you close the loan early, but charges a 4% fee. Every year the loan stays open you lose 2.5% on the gap between what you pay and what you earn. The question is whether 4 paid today is less than the present value of three years of that 2.5% gap. Hiranyak's tender offerAn offer by an issuer to buy back its own bonds from holders at a stated price for a limited period. is exactly this trade. The fact that the bonds trade at 103 is not the cost to Hiranyak; it is the price at which holders would sell to anyone else, and the 1 point above it is the incentive to sell back.

The relationship
PV of keeping the bonds=9.5×2.624+1001.073=24.93+81.63=106.56\text{PV of keeping the bonds} = 9.5 \times 2.624 + \frac{100}{1.07^3} = 24.93 + 81.63 = 106.56
9.5coupon per 100 face, paid each year for three years
2.624the three-year annuity factor at 7%
100 / 1.07^3principal at maturity, discounted three years at 7%
What it says in wordsAt the rate its cash earns, keeping the bonds costs Hiranyak 106.56 per 100 in today's money, so any tender price below that saves money.
A tender is a present value trade, not a coupon comparisonPremium over par paid nowRs 32 crore (4 per 100)PV of coupons saved, net of7% lost on the cash, at 7%Rs 52.5 croreNet gain to HiranyakRs 20.5 crore2.5 x 3 years, no discountingUndiscounted claim: Rs 60 crore, overstatedPer Rs 800 crore of bonds, if every holder tenders. Bar scale: 0 to Rs 80 crore.
Hiranyak pays a Rs 32 crore premium over par now and saves coupon worth Rs 52.5 crore in present value after the interest lost on the cash, a net gain of Rs 20.5 crore; adding the savings up without discounting would claim Rs 60 crore.
Step 2Why do the two ways of doing the sum give the same answer?

The first way values the bond at 7% and compares it with 104: 106.56 minus 104 is 2.56. The second way compares the premium of 4 with the present value of the yearly saving, 2.5 times 2.624, which is 6.56. Both are the same statement, because a bond discounted at a rate below its coupon is worth par plus the present value of the extra coupon. Knowing both lets you check yourself out loud. Per Rs 800 crore that is Rs 20.5 crore. Notice also that the market prices the bonds at 103, a yield of about 8.33%: investors discount Hiranyak's credit at a higher rate than its deposits earn, which is exactly why buying the debt back is cheap from the company's side.

Step 3What would make you hesitate?

Three things. The cash must genuinely be surplus: a steel company in a downturn may wish it had kept Rs 830 crore of liquidity rather than saved Rs 20 crore. Second, take-up: if only 60% of holders tender, the gain scales down to about Rs 12 crore and the fixed costs of running the offer stay the same. Third, the discount rate: if the cash could earn 9.5% elsewhere in the business, the gain disappears, so ask what else the money could fund. Tax treatment of the premium and the timing of deductions can move the answer at the margin; confirm the current rules rather than assuming them.

Where candidates lose it

The usual error is comparing 2.5% a year for three years, 7.5, with the 4 premium and declaring a gain of 3.5. That ignores the time value of money and overstates the gain by about a third.

The second is treating the 1 point above the market price as a loss. The market price is what an outside buyer pays; the company's own benchmark is the present value of what it would otherwise owe.

What the interviewer asks next

  • At what tender price does Hiranyak break even?
  • Would you rather do an open-market buyback at 103? What is the catch?
  • How does an early tender premium change holder behaviour, and why use one?
  • If the bonds were callable at 102 next year, how would that change the offer?

Company names and figures are illustrative.