Group Case Submission – Term III IIMC

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Corporate  Finance    

Group  Case  Submission    

Lyons  Document  Storage  Corporation              

Submitted  by:  Group  E11  Section  E  

 Priyabrata  Bisoi  (0249/49)  

Rahul  Deb  (0254/49)  Rahul  Gautam  (0255/49)  Satish  Kumar  (0301/49)  

     

Group Case Submission – Term III IIMC

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Lyons  Document  Storage’s  controller,  Eric  Petro,  told  Rene  that  the  bonds  were  issued  in  1999  at  a  discount  and  that  only  approximately  $  9.1  million  was  received   in  cash.  Explain  what   is  meant  by  the   terms   “premium”   or   “discount”   as   they   relate   to   bonds.   Compute   exactly   how   much   the  company  received  from  its  8%  bonds  if  the  rate  prevailing  at  the  time  of  the  original  issue  was  9%  as  indicated   in  Exhibit   2.  Also   re-­‐compute   the  amounts   shown   in   the  balance   sheet  at  December  31,  2006  and  December  31,  2007,   for  Long-­‐Term  Debt.  What   is   the  current  market  value  of   the  bonds  outstanding  at  the  current  effective  interest  rate  of  6%?  

 Premium  and  discount  are   terms   referring   to   the  difference   in   face  value  of   the  bond  

and  the  amount  received  by  the  borrower  at  the  time  of  issue.  Bonds  selling  at  a  price  greater  than  face  value  is  said  to  be  at  a  premium  and  the  difference  is  called  premium.  If  market  rate  of  interest  is  less  than  coupon  rate,  the  bond  can  be  issued  at  a  premium.    

Bonds   selling   at   a   price   lesser   than   face   value   is   said   to   be   at   a   discount   and   the  difference   is  called  discount.   If  market  rate  of   interest   is  greater   than  coupon  rate,   the  bond  can  be  issued  at  a  discount.  

The  market   rate  at   the   time  of   issue  was  9%,  and   the  bond  coupon   rate  was  8%  paid  semi-­‐annually(semi-­‐annual  payments  of  $4,00,000)Cash  amount  received  by  Lyons  at  the  time  of  issue  is  calculated  by  NPV(excel  formula)  using  parameters  4.5%(rate),  40  coupon  payments  of  400000  each  and  10000000(  face  value)  .  The  output  comes  out  to  be  $  90,79,920.78  which  is  the  amount  received  by  Lyons  Corp  at  the  time  of  bond  issue    

Payment  Date   Payment  

Liability  at  beginning  of  

period  

Semi-­‐Annual  Interest    

Liability  at  end  of  period  before  payment  

Liability  at  end  of  period  after  payment    

02/01/00   400000   $  90,79,920.78   $  4,08,596.44   $  94,88,517.21   $90,88,517.21  02/07/00   400000   $  90,88,517.21   $  4,08,983.27   $  94,97,500.49   $90,97,500.49  02/01/01   400000   $  90,97,500.49   $  4,09,387.52   $  95,06,888.01   $91,06,888.01  02/07/01   400000   $  91,06,888.01   $  4,09,809.96   $  95,16,697.97   $91,16,697.97  02/01/02   400000   $  91,16,697.97   $  4,10,251.41   $  95,26,949.38   $91,26,949.38  02/07/02   400000   $  91,26,949.38   $  4,10,712.72   $  95,37,662.10   $91,37,662.10  02/01/03   400000   $  91,37,662.10   $  4,11,194.79   $  95,48,856.90   $91,48,856.90  02/07/03   400000   $  91,48,856.90   $  4,11,698.56   $  95,60,555.46   $91,60,555.46  02/01/04   400000   $  91,60,555.46   $  4,12,225.00   $  95,72,780.45   $91,72,780.45  02/07/04   400000   $  91,72,780.45   $  4,12,775.12   $  95,85,555.57   $91,85,555.57  02/01/05   400000   $  91,85,555.57   $  4,13,350.00   $  95,98,905.57   $91,98,905.57  02/07/05   400000   $  91,98,905.57   $  4,13,950.75   $  96,12,856.32   $92,12,856.32  02/01/06   400000   $  92,12,856.32   $  4,14,578.53   $  96,27,434.86   $92,27,434.86  02/07/06   400000   $  92,27,434.86   $  4,15,234.57   $  96,42,669.43   $92,42,669.43  02/01/07   400000   $  92,42,669.43   $  4,15,920.12   $  96,58,589.55   $92,58,589.55  

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02/07/07   400000   $  92,58,589.55   $  4,16,636.53   $  96,75,226.08   $92,75,226.08  02/01/08   400000   $  92,75,226.08   $  4,17,385.17   $  96,92,611.26   $92,92,611.26  02/07/08   400000   $  92,92,611.26   $  4,18,167.51   $  97,10,778.76   $93,10,778.76  02/01/09   400000   $  93,10,778.76   $  4,18,985.04   $  97,29,763.81   $93,29,763.81  02/07/09   400000   $  93,29,763.81   $  4,19,839.37   $  97,49,603.18   $93,49,603.18  02/01/10   400000   $  93,49,603.18   $  4,20,732.14   $  97,70,335.32   $93,70,335.32  02/07/10   400000   $  93,70,335.32   $  4,21,665.09   $  97,92,000.41   $93,92,000.41  02/01/11   400000   $  93,92,000.41   $  4,22,640.02   $  98,14,640.43   $94,14,640.43  02/07/11   400000   $  94,14,640.43   $  4,23,658.82   $  98,38,299.25   $94,38,299.25  02/01/12   400000   $  94,38,299.25   $  4,24,723.47   $  98,63,022.71   $94,63,022.71  02/07/12   400000   $  94,63,022.71   $  4,25,836.02   $  98,88,858.74   $94,88,858.74  02/01/13   400000   $  94,88,858.74   $  4,26,998.64   $  99,15,857.38   $95,15,857.38  02/07/13   400000   $  95,15,857.38   $  4,28,213.58   $  99,44,070.96   $95,44,070.96  02/01/14   400000   $  95,44,070.96   $  4,29,483.19   $  99,73,554.15   $95,73,554.15  02/07/14   400000   $  95,73,554.15   $  4,30,809.94   $  1,00,04,364.09   $96,04,364.09  02/01/15   400000   $  96,04,364.09   $  4,32,196.38   $  1,00,36,560.48   $96,36,560.48  02/07/15   400000   $  96,36,560.48   $  4,33,645.22   $  1,00,70,205.70   $96,70,205.70  02/01/16   400000   $  96,70,205.70   $  4,35,159.26   $  1,01,05,364.95   $97,05,364.95  02/07/16   400000   $  97,05,364.95   $  4,36,741.42   $  1,01,42,106.38   $97,42,106.38  02/01/17   400000   $  97,42,106.38   $  4,38,394.79   $  1,01,80,501.16   $97,80,501.16  02/07/17   400000   $  97,80,501.16   $  4,40,122.55   $  1,02,20,623.72   $98,20,623.72  02/01/18   400000   $  98,20,623.72   $  4,41,928.07   $  1,02,62,551.78   $98,62,551.78  02/07/18   400000   $  98,62,551.78   $  4,43,814.83   $  1,03,06,366.61   $99,06,366.61  02/01/19   400000   $  99,06,366.61   $  4,45,786.50   $  1,03,52,153.11   $99,52,153.11  02/07/19   10400000   $  99,52,153.11   $  4,47,846.89   $  1,04,00,000.00   $0.00  

 Using  the  above  table,  we  can  compute  the  long-­‐term  debt  at  the  end  of  each  period.    

Balance  sheet  for  Long  term  debt  at  December  31st  2006  =  $92,58,589.55   Balance  sheet  for  Long  term  debt  at  December  31st  2007=    $92,92,611.26  

     Current  market  value  of  bonds  at  6%  market  rate  is  $1,15,41,502.41(approx.  $11.54  million)    Note:  Above  value   found  by   the  excel   formula  PV  using  parameters  3%(rate),   21   (number  of  

periods),  400000  (coupon  payment),  10000000  (face  value)                

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If  you  were  Rene  Cook,  would  you  recommend  issuing  $10  million,  6%  bonds  on  January  2,  2009  and  using  the  proceeds  and  other  cash  to  refund  the  existing  $10  million,  8%  bonds?  Will  it  cost  more,  in  terms  of  principal  and  interest  payments,  to  keep  the  existing  bonds  or  to  issue  new  ones  at  a  lower  rate?  Be  prepared  to  discuss  the  impact  of  a  bond  refunding  on  the  following  areas:    

• Cash  flows    • Current  year’s  earnings  • Future  year’s  earnings  

Note:   For   purpose   of   your   computations,   assume   that   refunding,   if   selected,   occurs   effective  January  2,  2009,  at  a  price  of  $1,154.15  per  bond.   Ignore   the  effects  of   income   taxes.  How  many  new  $1,000  bonds  will  Lyons  have  to  issue  to  refund  the  old  9%  bonds?    The   current   market   price   of   8%   bonds   is   $1,154.15   per   bond.   Cook   needs   $11.54   million  (1,154.15*10000)  for  retirement  of  old  bonds.  As  the  coupon  rate  is  same  as  the  current  market  rate  (6%)  so  each  new  bond  will  fetch  $  1000.  $10  million  will  be  available  from  the  issuance  of  10,000  new  bonds.  This  would  require  them  to  spend  $1.54  million  ($1541502.41)  from  their  own  pocket.      The  impact  of  bond  refunding  on  below  three  areas  is    

Cash  Flows:  Cook  (Lyons)  has  to  spend  $  1.54  million  from  its  own  pocket.  However   in   later  periods,  cash  flow  will   improve,  as  it  will  have  to  pay  $1,00,000  less  every  period  (6  months)  for  20  periods  due  to  lower  coupon  rate.  It  will  also  be  paying  interest  for  one  less  period.  

Current  Year’s  earnings:  It  will  show  an  outflow  of  $  2.24  million  as  current  liability  was  $  9.3  million  and  the  old  bond  were  retired  at  $  11.54  million  (current  market  value)  

Future  year’s  earnings:  It  will  pay  $  100,000  less  for  the  next  20  periods  (1  period=  6  months)  and  1  interest  payment  less.    So  the  future  earnings  will  improve.    

From  calculations  in  excel  sheet  we  found  out  Saving  in  Principal  by  issue  of  new  bonds            =  [10000000/  (1.03^21)]  -­‐  [10000000/  (1.03^20)]  =  -­‐$  1,61,264.783  Saving  in  Interest  payments  by  issue  of  new  bonds  =  $  17,02,767.20    Sum  of   the   above   two   equals   the   extra   amount   it   has   to   pay   now   to   retire   old   bonds.   Taking   into  account,  Time  Value  of  Money  there   is  no  difference   in  the  PV  of  both  options.  So   from  accounting  standpoint,  Cook  can  go  ahead  with  either  of  the  two  options.    To  retire  the  old  bonds  entirely  by  issuing  new  bonds,  they  have  to  issue  11542  new  bonds  (worth  $  11.54  million)  with  6%  coupon  rate  paid  semi-­‐annually.      

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Assume  6%  bonds  could  be  issued  and  the  proceeds  used  to  refund  the  existing  bonds.  Compare  the  effects   of   these   transactions   with   those   calculated   in   Question   2.   If   you   were   Rene   Cook,   what  amount  of  new  bonds  would  you  recommend  and  why?      The  two  options  found  from  Q  2  are  

i) Issuing  10,000  new  bonds  and  paying  the  remaining  amount  from  own  pocket  ii) Issuing  11,542  new  bonds  to  entirely  finance,  retirement  of  old  bonds.    

Since  there   is  no  difference   in  the  PV  of  either  alternative,   from  an  accounting  perspective,  Cook  could  be  indifferent  between  either  of  the  alternatives.  

Option  (i)  requires  a  outflow  of  $  1.54  million  and  will  reflect  a  huge  loss  of  $  2.24  million  in  the  current  year,  which  would  be  difficult  to  explain  to  the  shareholders.  Since  David  Lyons  wouldn’t  be  happy  with  low  earnings  and  shrinking  growth  rate  so  the  above  option  was  undesirable.  

Since   David   Lyons   was   interested   in   replacing   8   %   bonds   with   bonds   having   lower   interest   rates,  therefore  Cook  should  issue  11,542  new  bonds  to  fully  finance  refunding  of  old  bonds.