GSB CorpFin Inc. is considering issuing debt to finance its expansion in a strategic consulting division. Detailed analysis by the firm shows that an initial investment needed is $100mln and the present value of cash flows from this expansion (excluding the initial investment) is $500mln. $100mln is a fixed cost and the investment opportunity either needs to be taken in full or not taken at all. The value of all assets in place (in other words, the present value of all cash flows apart from those generated by the planned expansion) is $1,500mln. Currently, the firm has only equity in its capital structure.
The firm needs to raise $100mln and the CFO asked their investment bankers, Silverman Cranley, for advice. Silverman Cranley offered two choices. First, GSB CorpFin can issue a straight corporate note. The note will have a maturity of 6 years with a 7% annual coupon (paid once a year) and the principal of $100mln. The first coupon is due exactly one year from now. Silverman Cranley believes that the market will find 7% coupon reasonable and representing a fair value of debt.
The second option is to issue the following security: the firm will not make any interest payments for the first three years, and then will pay 8% annual coupon (starting with the fourth year) for the next 6 years when the principal of $110mln is due. Silverman Cranley is ready to make a firm commitment to pay $100mln for this issue.
Andy Marsh, the CFO, is uncertain of which issue to choose. On the one hand, not paying any interest for the first three years seems attractive. On the other hand, the interest rate is higher and will be paid on $110 mln rather than $100 mln principal.
Disregard all tax considerations (i.e. assume that the marginal corporate tax rate is zero) and ignore investment bank fees in answering this question. Assume that the yield curve is flat (in other words, discount rate is constant across maturities) and debt payments in both options have the same risk.
WHAT IS THE NPV OF OPTION 1 and 2?
The solution explains how to calculate the NPV of two options for a bond issue