Orpin Industries Ltd. is about to make its first bond issue in the public market. Orpin is a small but growing company, and its shares are starting to be recognized. For the past two years, they have consistently traded at a price equal to 12 times the after-tax earnings per share.
The proposed bond issue will raise $20,000,000, which will be used to expand the corporation’s retail operations into western Canada. The expanded operations should provide a minimum return on investment of 22%.
After receiving financial advice, the company decides to issue the bonds in units of $1,000 with an annual interest rate of 10% (interest payable annually). The financial advisor indicates that at this interest rate, the bonds can be sold (with a 10-year term) at their par value. Just before the issue date, long-term interest rates in the market increase by half a percent.
Or pin realizes that it will have to issue its bonds at a discount in order to obtain the full $20,000,000. Alternatively, the company could delay the issue for a short time, revise the prospectus, and print new bonds to reflect the higher interest rate. This would, of course, create additional costs. Before making the decision, Or pin wants to know if there would be any benefit to revising the interest rates.
Or pin is subject to a 25% tax rate.
Required:
1. If Or pin issues the bonds as originally proposed (that is, with an interest rate of 10%), how much will it have to discount them? Ignore any tax implications to the potential investors.
2. Based on your answer to 1, determine the after-tax cost of financing the bond issue under both the discount option and the revised interest rate option.
3. Assuming that the interest rate on the bond is revised, how may this affect the trading value of Orpin’s common shares?
4. If the company chooses to issue the bonds at a discount, could the amount of the discount be affected by the tax treatment to the potential investor? Explain.