Seminole Gas and Electric

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Seminole Gas and electric case study

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Seminole Gas and Electric

  1. 1. Case presentation on Seminole Gas and Electric Presented By  Anushuya Dahal  Arogya Joshi  Bishal Khanal  Deepti Koirala  Dinesh Adhikari  Erika Shakya  Gyanesh Bajracharya
  2. 2.  Norman Cahill, financial president of Seminole Gas and Electric.  Seminole should refund a $500 million issue of 26 years, 16 percent, mortgage bonds issued 11 months earlier.  In less than a year later rated utility bonds such as those of Seminole can be sold to yield only 12.5 %.  After the $500 million was sold, Cahill anticipated a decline in interest rates so the bonds made immediately callable.  Investment bankers handling the issue wanted Seminole to make the bonds non-callable for 5 year period.
  3. 3. o The bankers insisted on call premium of 10 % if any bonds were called during the first year. o Seminole could sell a new issue of 25 year bond at an interest rate of 12.5 %. o The call of old and sale of new bonds take place in about five to seven weeks. o The flotation cost on refunding issue would be approximately 0.5 to 1 percentage and there would be a period of approximately 3 weeks during which both issues would be outstanding. o During this period, the excess fund is invested in short term treasury securities yielding to 10 %.
  4. 4. Issue 1: Initial investment S.No Particular Before Tax ($) After Tax ($) 1 Call premium (50,000,000) (30,000,000) 2 Flotation cost on New Issue (2,500,000) (2,500,000) 3 Tax Saving on old issue Flotation cost 2,625,000 1,050,000 4 Extra Interest Cost on old Issue (4,615,384.615) (2,769,230) 5 Interest earned on short term investment 2,884,610.586 1,730,770 Initial investment Outlay (32,488,460) Here, Initial investment outlay for the Seminole Gas and Electric Company that undertaking the refunding decision is $32,488,460.
  5. 5. Calculation of Call Premium Call premium on old issue Issue amount * Call premium Before tax $500 million*0.1 = $50 million After tax Issue amount* Call premium (1-t) After tax $50 (1-0.4 ) = $30 million Calculation of Floatation Cost on Old issue and New issue Flotation cost on old issue unamortized flotation cost* tax rate Old issue 2625000*0.4 = $1.05 million Flotation cost in new issue Issue amount * flotation cost percent New issue $500 million * 0.5% = $2.5 million Calculation of additional interest expenses Int. Exp. Old issue*Old interest rate *(Overlapping weeks/ Total weeks in a year)*(1-t) Before tax $500million* 3/52*0.16 = $4615384.615 After tax $4615384.615 (1-0.40) = $2.76923 million Calculation of additional interest income Additiona l Interest Income Old issue *Return on short term investment*(overlapping weeks/ Total weeks in a year)*(1-t) Before tax $ 500million*0.10*3/52 = $2884610.586 After tax $2884610.586* = $1.73077 million
  6. 6. Issue 2: Net present value S.no Particular After Tax($) PVFIA7.5%,25 = 11.1469($) 1 Initial Investment Outlay (32,488,460) 2 Annual Tax saving on New issue 445,876 3 Annual lost tax savings from old issue float cost (468,170) 4 Interest payment on old issue 48,000,000 535,051,200 5 Interest payment on new issue (37,500,000) (418,008,750) Net present value of savings 84,531,696 Net present value of savings, as Norman Cahill believes that the savings of 3.5 percent a years for 25 years on a $500 million issues would be well worth the refunding cost. Our calculation shows a positive NPV i.e. $84,531,696 which is worth will to refund the old bond and issue of the new bond.
  7. 7. Calculation the annual tax saving on new issue Tax savings on floatation cost on the new issue Total Floatation Cost (i.e. 0.5%of 500 million)/life in year}* Tax Rate * PVIFA7.5%, 25years = 2.5 million /25*0.4*11.1469 = $445,876 Tax benefits lost on floatation costs on the old issue = Unamortized old floatation cost/Life*Tax Rate* PVIFA7.5%, 25years = $2,625,000/25*0.40*11.1469 = $468,170 million. Calculation of the Interest payment on new issue Interest on new bond after tax $500 million* 12.5 %*( 1-tax rate) = 500*0.125*0.6 = $37,500,000 Calculation of interest payment on old bond Interest on Old bond after tax = $500 million* 16%*0.6 = $48,000,000
  8. 8. Issue 3: Critiques of various board members Claude Dykeman: A long- term member of the board and the chairman of the Dykeman, McClary and Company Believes that calling the bonds for refunding would not be well received by the major financial institutions that hold the firm’s outstanding bonds. However, if the company doesn’t refund its bond then the company could find itself locked into a high rate for many years
  9. 9. Dennis Ryan: • A relatively new member of the board and president of a local bank also opposed the call but for entirely different reason. • We cannot say the interest rate might come down to 10 percent with certainty. Scott Kearney: • President of a management consulting firm specialized in utility operations • His concern is all about high call premium, floatation cost on the refunding issue, the firms overall 14.5% cost of capital. • Suggested the use of discounted cash flow techniques for the purpose of analysis.
  10. 10. Cahill: • Thought it might not be better to modify the Discounted Cash Flow (DCF) analysis, if company follows this analysis then cost- of –debt is used instead of its average cost-of-capital. • He speculates about before or after tax figure should be employed Critique : • Because of positive net saving that has been calculated in issue 2, it can be concluded that this issues rose by the person are only the small but widely held confusion. • The premium and floatation cost wouldn’t be the problem and after tax cost of new debt should be used to find the proper solution or alternative in this case.
  11. 11. Issue 4: Decision S. no Particular PVFIA7.5%,25 = 11.1469($) 1 Call premium (30,000,000) 2 Flotation cost on New Issue (2,500,000) 3 Tax Saving on old issue Flotation cost 1,050,000 4 Extra Interest Cost on old Issue (2,769,230) 5 Interest earned on short term investment 1,730,770 Initial investment Outlay (A) (32,488,460) 6 Annual Tax saving on New issue 445,876 7 Annual lost tax savings from old issue float cost (468,170) Annual flotation cost tax effect (B) (22,294) 8 Interest payment on old issue 535,051,200 9 Interest payment on new issue (418,008,750) Net interest Saving (C) 117,042,450 NPV of Refunding Decision ( A+B+C) 84,531,696 NPV of the refunding is positive, it would be profitable to refund the old bond issue. Our calculation shows a positive NPV i.e. $84,531,696. which is worth will to refund the old bond and issue of the new bond. Hence we strongly recommend Norman Cahill to undertake refunding operation this time.
  12. 12. Issue 5: Merit of using after tax current bond rate  The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flow; the greater the uncertainty of future cash flows, the higher the discount rate.  The discount rate is used to evaluate the future interest saving through cash flow.  The estimation of future interest is done on basis of various assumptions such as price of securities, volume of sale, earning, and state of the economy and so on.  Through discount rate company will be able to calculate present value and net present value so that earning can be reflected.
  13. 13. The relative merits of using after tax current of bonds as opposed to the after tax average cost of capital are mentioned as follows: o Cash flows are more certain: o Less risky o Ease on future estimation: o Provides more accurate results: o Ease on future estimation:
  14. 14. Issue 6: Particular Amount in $ Call premium on old issue after tax (28.5 million) Floatation Cost on New issue (2.5 million) Floatation Cost on Old issue 1.03 million Additional Interest Expenses (2.76923 million) Additional Interest Income 1.73077 million Initial Investment Outlay ($31.00846 million) Amortization Tax Saving ($0.01493) million Interest Saving $230.09 million Net Present Value of Saving $199.0661 As we can see if the yield curve were downward sloping and if Cahill felt that “the market knows more than I do” about the future course of interest rates , it is recommended for the company to postpone the refunding operation for now and perform the refunding operation after six months when the interest rate will decline to 10%.
  15. 15. Call premium on old issue after tax: =$500 million*(1-t)*0.095 =$28.5 million Floatation Cost on New issue: = Amount of issue * Floatation cost percentage =$500 million*0.5% =$2.5 million Floatation Cost on Old issue: =Unammortization flotation cost* Tax Rate =$2.5726722*0.4 =$1.03 million Additional Interest Expenses: =Old issue*Old interest rate *(overlapping weeks/ Total weeks in a year)*(1-t) =$500*16%*3/52*(1-0.4) =$2.76923 million Additional Interest Income: = Old issue *Return on short term investment*(overlapping weeks/ Total weeks in a year)*(1-t) = $500*10%*3/52*0.6 =$1.73077 million
  16. 16. Tax Saving on Floatation Cost on the New Issue per Year: = {Total Floatation Cost (i.e. 0.5%of 500 million)/life in year}* Tax Rate * PVIFA6%, 25years = 2.5/25*0.4*12.7833 = $0.511332 million Tax Benefit Lost on Floatation Cost on the Old Issue: = Unamortized old floatation cost/Life*Tax Rate* PVIFA6%, 25years = $ 2.573/25*0.40*12.7833 =$ 0.526262 million. Amortization Tax Saving = $0.511331 - $0.52626 = ($0.01493) m  Interest on new bond after tax(a) = $500 million* 10 %*( 1-tax rate) = 500*0.1*0.6 = $30 million  Interest on Old bond after tax(b) = $500 million* 16%*0.6 = $48 million Now Total Interest Saving = (b – a)* PVIFA 7.5% 25years (Since Annual interest saving = Interest on Old bond – Interest on new bond) = (48 – 30)* 12.7833 = $230.09 million
  17. 17. Graphical presentation of comparing NPV 84.531696 199.0661 NPV CURRENT NPV AFTER 6 MONTH NPV ($ Million) NPV ($ Million)
  18. 18.  Interest rate on bond has been decreasing substantially.  Problem is to identify the proper decision for the company, whether the bond is refund or hold.  Present value of the savings is positive, which indicates that the decision of refunding is beneficial to the Seminole Gas and Electric.  NPV of refunding is positive. So we would recommend the firm to perform refunding operation.  It is recommended for the company to postpone the refunding operation for now and perform the refunding operation after six months when the interest rate will decline to 10%.

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