Mary,
I am not sure how they are reducing this debt.
At some point in time, this company sold a bunch of bonds on which they were committed to paying 11.5% interest. The terms of the bond was that they would pay back the principal on May 1, 2004 (this is the maturity date). The terms of the bond must contain conditions that allow them to pay off the bonds early if they pay a premium price (to compensate the bond holders for lost interest). They are redeeming it for 105.75 percent, which means that for every $100 worth of bonds a bond holder has, they will be paid $105.75.
Now why would they buy back the bonds at a premium, rather than paying 11.5% interest and paying them back at par in 2004? Well, if they can borrow money at a much cheaper rate, or have the cash sitting around then they will probably realise some savings.
Let's look at one possible scenario. Let's say that they can issue new debt due on 1-Jun-2004 at 8%, and assume that they expect the average interest rate on cash to be 6% between 1-Jun-1999 and 1-Jun-2004.
First, lets figure out what the face value of the bonds is worth. Since they are paying $172.15 to redeem the bonds at a 5.75% premium, then the face value of the bonds is 172.15 / 105.75 = $162.79 (all figures in millions of dollars).
So we have two scenarios to compare:
1) Keep paying 11.5% interest on $162.79 every 1-May, until 1-May-2004, and then redeem the bonds for $162.79
vs
2) Borrow $172.15 now, buy back the bonds at a premium, then pay 8% interest every 1-Jun until until 1-Jun-2004 at which point the $172.15 must be paid to redeem the new debt.
In order to determine the difference between the two scenarios, you need to sum up the present value of all future cash outflows for each scenario. (Note: To simplify things a bit, I am making two assumptions: the first is that 1-Jun-1999 is the present. Also, I am going to arbitrarily modify the terms of the original bond, so that the interest payments after 1-May-1999 are made on 1-Jun and that the redemption date is 1-Jun-2004. Shifting these payments by one month shouldn't affect things very much).
If you're not familiar with the concept of present value, it can be kind of difficult to conceptualise. It is based on the idea that a dollar now and a dollar in the future are not the same. If you put a dollar in an interest bearing bank account, then in the future your dollar will have grown to $1, plus any interest that you have earned.
Here's an example: Lets say that I need to pay $100 to you a year from now, and I know that I can get buy a certificate at the bank that guarantees me 4% per year, and matures 1 year from now. If I buy a GIC for $100 / (1 + 4%) = $96.15, then in one year, it will be worth $96.15 plus the interest, which is 4% * 96.15 = 3.85. Now $3.85 + $96.15 = $100. So $100 a year from now, is worth only $96.15 now (assuming that I can get 4% interest). Another way of putting this is that the PV of $100 a year from now is $96.15.
Another example, let's say that I need to pay you $100 two years from now, and I can buy a 2-year compounded GIC that pays 4.5% annually. How many $ would I have to put in the GIC so that it is worth $100, two years from now. Well one year from now, it would have to be worth $100 / 1.045 or $95.69. And so this year I would have have to be worth $95.69 / 1.045 or $91.57. So $100 two years from now, is only worth $91.57, assuming an annual compounded interest rate of 4.5%. Another way of saying this is that the PV of $100 two years from now is $91.57.
The discount factor (i.e., the multiplier to use to convert future dollars into present dollars) is 1 / compound interest multiplier.
So under each of the two scenarios that we want to compare, we have different payments at different points in time. It is hard to compare numbers this way, since the dollars in each year are not worth the same amount. The solution to the problem is to use discount factors to figure out what the PV of each stream of cash flows is worth on the same date (in our case, we will use 1-Jun-1999).
Our first step in figuring out the PV of the cash flows is to figure out the discount factors to use for each year between 1-Jun-1999 and 1-Jun-2004. We are assuming that the average interest rate for cash will be 6% between now and 2004. Here are the compount interest rate multipliers between now and 2004.
1-Jun-2000 1.06
1-Jun-2001 1.06 * 1.06 = 1.12
1-Jun-2002 1.06 * 1.06 * 1.06 = 1.19
1-Jun-2003 1.06 * 1.06 * 1.06 * 1.06 = 1.26
1-Jun-2004 1.06 * 1.06 * 1.06 * 1.06 * 1.06 = 1.34
Now we can calculate what the present value of the principal and interest. For the first scnario, the principal was $162.79, which means that the annual interest payments are $162.79 * 11.5% = $18.72. Also, on 1-Jun-2004, we will have to come up with $162.79 to pay off the principal.
Date Payment NPV Of Payment at 1-Jun-1999
1-Jun-2000 18.72 (i) 18.72 / 1.06 = 17.66
1-Jun-2001 18.72 (i) 18.72 / 1.12 = 16.66
1-Jun-2002 18.72 (i) 18.72 / 1.19 = 15.72
1-Jun-2003 18.72 (i) 18.72 / 1.26 = 14.83
1-Jun-2004 18.72 (i) 18.72 / 1.34 = 13.99
1-Jun-2004 162.79 (p) 162.79 / 1.34 = 121.65
(i) = Interest Payments
(p) = Principal
So the present value of the future interest payments at 1-Jun-1999 is $78.86 and the present value of the principal is $121.65. The total PV of the interest payments plus the principal at 1-Jun-1999 is $200.50.
Now lets wee what the PV of the $172.15 borrowed at 8% is. First of all, the annual interest payments will be $13.77 starting on 1-Jun-2000. The payments will look like this:
Date Payment NPV Of Payment at 1-Jun-1999
1-Jun-2000 13.77 (i) 13.77 / 1.06 = 12.99
1-Jun-2001 13.77 (i) 13.77 / 1.12 = 12.26
1-Jun-2002 13.77 (i) 13.77 / 1.19 = 11.56
1-Jun-2003 13.77 (i) 13.77 / 1.26 = 10.91
1-Jun-2004 13.77 (i) 13.77 / 1.34 = 10.29
1-Jun-2004 172.15 (p) 172.15 / 1.34 = 128.64
So the PV of the future interest payments at 1-Jun-1999 is $58.01 and the PV of the principal is $128.64. The total PV of the interest payments plus the principal at 1-Jun-1999 is $186.65.
So to summarize:
Present Value of Future Cash Flows Under Original Terms: $200.50
Present Value of Future Cash Flows Under Modified Terms: $186.65
Savings to the company: $13.85 (in June 1, 1999 dollars)
So there you go. Assuming that they refinanced at a low enough rate, its a good thing for the shareholders!
I hope that I didn't screw this up. If I have, I'm sure that someone who knows more than me will be quick to point out my mistakes.
I often wonder how I come across on these boards sometimes...this stuff is sooooo new to me...I have questions...but not sure how to even go about phrasing them without sounding foolish
Mary, don't worry how you come across on these boards. Everyone here was in the same position that you were at some point in time (when I think of what I knew when I first started out, I'm surprised that I have any money left at all). I think that you are smart to recognize where your knowlege is limited, and are not afraid to ask for information. A lot of this stuff is not rocket science, but there is a lot to learn - the jargon can make things diffucult to understand. Remeber too that this jargon can be used by fast talkers to lure you into a situation where they can convert your money into their money.
To be honest, based on the expertise of the people posing on this thread, I am taking a risk in making this post, since I will look foolish if I make a mistake. Oh well. If I did make a mistake it will be a learning experience....
eom John Sladek
P.S. Sorry about the spelling mistakes - its getting late... |
