Case 062Bond issuance and executionWarm up

A company issues Rs 300 crore of three-year bonds at 8.40% and pays an arranger fee plus rating, trustee and listing costs. What is its all-in cost of funds?

The situation

Bhavnika Electricals issues Rs 300 crore of three-year bonds at an 8.40% coupon, paid yearly, with the full amount repaid at maturity. The arranger charges 0.15% of the issue size. Rating, debenture trustee and listing costs total Rs 60 lakh. All fees are paid on the issue date out of the proceeds.

The CFO has told the board that the bonds cost 8.40%.

Your task

What is the all-in cost of funds, which fees did you include, and which costs should the reader confirm before using the number?

Quick check

Roughly how much do the fees add to the yearly cost?

Worked solution

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

30-second answerThe answer to give first

The all-in cost is about 8.54%, not 8.40%. The arranger fee of Rs 45 lakh and Rs 60 lakh of other costs total Rs 1.05 crore, so Bhavnika receives Rs 298.95 crore but pays 8.40% on Rs 300 crore and repays Rs 300 crore. The yield on those cash flows is 8.54%. Stamp duty, exchange platform fees, tax on fees and yearly surveillance fees should be confirmed and added.

Step 1Why is the coupon not the cost?

When you take a personal loan at 12% with a processing fee, the bank hands over less than the loan amount but charges interest on the full amount. The true cost is the rate that equates what you actually receive with what you actually repay, and fees paid up front push it above the headline rate. Bhavnika receives Rs 298.95 crore, pays Rs 25.20 crore of coupon each year and repays Rs 300 crore. That gap of Rs 1.05 crore on day one is the only difference from a plain 8.40% bond, and it lifts the all-in cost of fundsThe yield computed from the net proceeds actually received and every payment actually made, including fees. to 8.54%.

The relationship
298.95=25.20(1+y)+25.20(1+y)2+325.20(1+y)3  ⇒  y≈8.54%298.95 = \frac{25.20}{(1+y)} + \frac{25.20}{(1+y)^2} + \frac{325.20}{(1+y)^3} \;\Rightarrow\; y \approx 8.54\%
298.95Rs 300 crore less Rs 45 lakh arranger fee and Rs 60 lakh of other costs
25.20yearly coupon, 8.40% of Rs 300 crore
325.20last coupon plus the Rs 300 crore repayment
What it says in wordsThe all-in cost is the rate that makes the net money received equal to the present value of every payment made.
The coupon is not the cost of funds8.35%8.40%8.45%8.50%8.55%8.30%8.40%Couponwhat investors get+0.059%Arranger feeRs 45 lakh, 0.15%+0.078%Rating, trustee,listing: Rs 60 lakh8.54%All-in costwhat it really paysAxis starts at 8.30% so the fees are visible; each fee is paid once and spread over three years.
Bhavnika's 8.40% coupon rises by 0.059% for the arranger fee and by 0.078% for rating, trustee and listing costs, so the all-in cost of funds is about 8.54%.
Step 2How do you check it without a spreadsheet?

Divide the fees by the issue and by the life: Rs 1.05 crore over Rs 300 crore is 0.35%, over three years about 0.117% a year. The quick answer, about 8.52%, is close to the exact 8.54% because the fees are small; the exact figure is a little higher because the fees are paid on day one while their benefit is spread over three years. The shortcut breaks down on short or small deals, where fixed costs are a bigger share, and it matters when two offers are within a few basis points of each other.

Step 3Which costs should be confirmed before quoting the number?

Name the frame and do not quote rates from memory. Stamp duty on the issue of debentures, the electronic bidding platform and depository charges, tax on the fees themselves, and the yearly rating surveillance and trustee fees all vary by instrument and over time, so each should be confirmed at issue. Yearly fees are different in kind from the up-front ones: they add to each year's payment rather than reducing the proceeds, and they should be put in the cash flows in the year they fall. If Bhavnika pays coupons half-yearly, the cash flows change again. The closing line to the CFO: the bonds cost about 8.54% before the items still to be confirmed, and the board should see that figure, not 8.40%.

Where candidates lose it

The trap is saying the cost of funds is 8.40%. That is what investors earn, not what Bhavnika pays, and comparing it with a bank loan quoted all-in makes the bond look cheaper than it is.

The opposite error is adding 0.35% to the coupon, as if all the fees were a cost of one year. They are spread over three.

What the interviewer asks next

  • Rating and trustee fees of Rs 10 lakh are payable every year instead of once. How does the all-in cost change?
  • The issue is Rs 50 crore instead of Rs 300 crore, with the same fixed costs. What is the all-in cost now?
  • Why might an issuer accept a higher all-in cost for a bond over a cheaper bank loan?

Company names and figures are illustrative.