Question

The Bowman Corporation has a bond obligation of $10 million outstanding, which it is considering refunding. Though the bonds were initially issued at 11 percent, the interest rates on similar issues have declined to 10.0 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a call premium of 7 percent on the old issue. The underwriting cost on the new $10,000,000 issue is $400,000, and the underwriting cost on the old issue was $290,000. The company is in a 35 percent tax bracket, and it will use an 9 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision. Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

a. Calculate the present value of total outflows.

b. Calculate the present value of total inflows.

c. Calculate the net present value.

Answer 1

Part a)

Step 1: Calculate Present Value of Annual Tax Savings

The present value of annual tax savings can be calculated with the use of PV(Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate (I/Y) = Interest Rate, Nper (N) = Period, PMT = Payment (here, Annual Tax Savings) and FV = Future Value (if any).

Here, Rate = 9%, Nper = 10, PMT = (Underwriting Cost on New Issue/Years)*Tax Rate = (400,000/10)*35% = $14,000 and FV = 0

Using these values in the above function/formula for PV, we get,

Present Value of Annual Tax Savings = PV(9%,10,14000,0) = $89,847.21

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Step 2: Calculate Net Cost of Annual Premium and Underwriting Expenditure

The net cost of annual premium and underwriting expenditure is arrived as below:

Net Cost of Annual Premium = Face Value of Bond Issue*Call Premium Rate*(1-Tax Rate) = 10,000,000*7%*(1-35%) = $455,000

Underwriting Expenditure = Underwriting Cost on New Issue = 400,000

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Step 3: Calculate Present Value of Total Outflows

The present value of total outflows is determined as follows:

Present Value of Total Outflows = Net Cost of Annual Premium + Underwriting Expenditure - Present Value of Annual Tax Savings = 455,000 + 400,000 - 89,847.21 = $765,152.79 (answer for Part a)

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Part b)

Step 1: Calculate Present Value of Interest Savings

The present value of interest savings can be calculated with the use of PV(Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate (I/Y) = Interest Rate, Nper (N) = Period, PMT = Payment (here, Net Annual Interest Savings) and FV = Future Value (if any).

Here, Rate = 9%, Nper = 10, PMT = Face Value of Issue*(Original Interest Rate - New Interest Rate)*(1-Tax Rate) = 10,000,000*(11% - 10%)*(1-35%) = $65,000 and FV = 0

Using these values in the above function/formula for PV, we get,

Present Value of Interest Savings = PV(9%,10,65000,0) = $417,147.75

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Step 2: Calculate Present Value of Unamortized Annual Cost on Old Issue

The present value of unamortized cost on old issue can be calculated with the use of PV(Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate (I/Y) = Interest Rate, Nper (N) = Period, PMT = Payment (here, Unamortized Annual Cost) and FV = Future Value (if any).

Here, Rate = 9%, Nper = 10, PMT = (Cost of Old Issue - Cost Amortized Till Date)/Years = (290,000 - 290,000/20*10)/10 = $14,500

Using these values in the above function/formula for PV, we get,

Present Value of Unamortized Cost on Old Issue = PV(9%,10,14500,0) = $93,056.04

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Step 3: Calculate Value of Immediate Gain in Unamortized Cost on Old Issue

The value of immediate gain in unamortized cost on old issue is arrived as below:

Immediate Gain in Unamortized Cost on Old Issue = Unamortized Cost on Old Issue - Present Value of Unamortized Cost on Old Issue = 145,000 - 93,056.04 = $51,943.96

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Step 4: Calculate Present Value of Total Inflows

The present value of total inflows is calculated as follows:

Present Value of Total Inflows = Present Value of Interest Savings + Immediate Gain in Unamortized Cost on Old Issue*Tax Rate = 417,147.75 + 51,943.96*35% = $435,328.14 (answer for Part b)

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Part c)

The net present value is determined as below:

Net Present Value = Present Value of Total Inflows - Present Value of Total Outflows = 435,328.14 - 765,152.79 = -$329,824.65 (answer for Part c)