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A B C D E F G H I J K L M N
Solution 11/16/2018
Chapter: Web 15B
Problem: 3
Current bond issue data
Par value 70,000,000$
Coupon rate 10%
Original maturity 30
Remaining maturity 22
Original flotation costs 4,500,000$
Call premium 10%
Tax rate 25%
Refunding data
Coupon rate 8.0000%
Maturity 22
Flotation costs 5,000,000$
Time between issuing new bonds and calling old bonds (months) 1
Rate earned on proceeds of new bonds before calling old bonds (annual)
5%
a. Perform a complete bond refunding analysis. What is the bond refunding's NPV?
Initial investment outlay to refund old issue:
Call premium on old issue = 7,000,000.00$
After-tax call premium = 5,250,000.00$
New flotation cost = 5,000,000.00$
Old flotation costs already expensed = 1,200,000.00$
Remaining flotation costs to expense = 3,300,000.00$
Tax savings from old flotation costs = 825,000.00$ You get to expense the remaining flotation costs
Additional interest on old issue after tax = 437,500.00$ This is interest paid on the old bond issue between when the new bonds are issued and the old bonds are retired
Interest earned on investment in T-bonds after tax = 218,750.00$ This is interest earned on the proceeds from the new bonds before they are used to pay off the old bonds.
Total investment outlay = 9,643,750.00$
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation = 56,818.18$
Tax savings lost on old flotation = 37,500.00$
Total amortization tax effects = 19,318.18$
Annual interest savings due to refunding:
Annual after tax interest on old bond = 5,250,000.00$
Annual after tax interest on new bond = 4,200,000.00$
Net after tax interest savings = 1,050,000.00$
Annual cash flows = 1,069,318.18$
After-tax cost of new debt = 6.00%
NPV of refunding decision = 3,232,532.27$
b. At what interest rate on the new debt is the NPV of the refunding no longer positive?
Schumann Shoe Manufacturer is considering whether or not to refund a $70 million, 10% coupon, 30-year bond issue that was sold 8 years
ago. It is amortizing $4.5 million of flotation costs on the 10% bonds over the issue's 30-year life. Schumann's investment bankers have
indicated that the company could sell a new 22-year issue at an interest rate of 8 percent in today's market. Neither they nor Schumann's
management anticipate that interest rates will fall below 6 percent any time soon, but there is a chance that interest rates will increase.
A call premium of 10 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million.
Schumann's marginal federal-plus-state tax rate is 25 percent. The new bonds would be issued 1 month before the old bonds are called,
with the proceeds being invested in short-term government securities returning 5 percent annually during the interim period.