The document presents a case study on Seminole Gas and Electric considering whether to refund high interest bonds. It analyzes the costs and savings of refunding now versus postponing for six months. Refunding now yields a positive NPV of $84.5 million. Postponing yields a higher NPV of $199 million as interest rates are expected to decline further. It is recommended to postpone refunding for now and reevaluate in six months.

1. Case presentation on
Seminole Gas and Electric
Presented By
 Anushuya Dahal
 Arogya Joshi
 Bishal Khanal
 Deepti Koirala
 Dinesh Adhikari
 Erika Shakya
 Gyanesh Bajracharya

3.  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.

4. 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 %.

6. 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.

7. 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

8. 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.

9. 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

10. 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

11. 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.

12. 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.

13. 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.

14. 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.

15. 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:

16. 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%.

17. 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

18. 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

19. Graphical presentation of
comparing NPV
84.531696
199.0661
NPV CURRENT NPV AFTER 6 MONTH
NPV ($ Million)
NPV ($ Million)

21.  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%.