TK Ltd. has 600 Lakh 12% Debenture outstanding with 5 years remaining to redemption. Since interest rates are decreasing, company is planning to…

(i) Calculation of initial outlay:- a. Face value 600 Add: Call premium 30 Less: Tax on Premium of Redemption 6 Cost of calling old bonds 624 b. Gross proceed of new issue 600 Less: Issue costs 10 Net proceeds of new issue 590 .: Initial outlay = 624 Lakh – 590Lakh = 34 Lakh (ii) Calculation of net present value of refunding the bond: Saving in annual interest expenses ₹(Lakh) [600 x (0.12 – 0.10)] 12.00 Less: Tax saving on interest (0.20 x 12) 2.40 Add: Tax Saving on Issue Exp. (10/5) x 0.20 0.40 Annual net cash saving 10.00 PVIFA (8%, 5 years) 4.0 .:Present value of net annual cash saving 40.00 Lakh Less: Initial outlay 34.00 Lakh Net present value of refunding the bond 6.00 Lakh Decision: 12% Debentures should be redeemed and new 10% Debentures should be issued because NPV of Bond Refunding decision is positive. Alternative Solution: Since in the Question specifically nothing has been mentioned about the writing off Issue Expenses for 10% Debentures, if students have assumed it to be written off at the time of issue in one go then solution will be as follows: (i) Calculation of initial outlay:- a. Face value 600 Add: Call premium 30 Less: Tax on Premium of Redemption 6 Cost of calling old bonds 624 b. Gross proceed of new issue 600 Less: Issue costs 10 Add: Tax Saving on Issue Expenses 2 Net proceeds of new issue 592 .: Initial outlay = 624 Lakh – 592Lakh = 32 Lakh (ii) Calculation of net present value of refunding the bond:- Saving in annual interest expenses ₹(Lakh) [600 x (0.12 – 0.10)] 12.00 Less: Tax saving on interest (0.20 x 12) 2.40 Annual net cash saving 9.60 PVIFA (8%, 5 years) 4.0 Present value of net annual cash saving 38.40 Lakh Less: Initial outlay 32.00 Lakh Net present value of refunding the bond 6.40 Lakh Decision: 12% Debentures should be redeemed and new 10% Debentures should be issued because NPV of Bond Refunding decision is positive.