Question

The Wagner Corporation has a $20 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 16 percent, the interest rates on similar issues have declined to 13.3 percent. The bonds were originally issued for 20 years and have 16 years remaining. The new issue would be for 16 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new $20 million issue is $550,000, and the underwriting cost on the old issue was $400,000. The company is in a 40 percent tax bracket, and it will allow an overlap period of one month (1/12 of the year). Treasury bills currently yield 5 percent. (Do not round intermediate calculations. Enter the answers in whole dollars, not in millions. Round the final answers to nearest whole dollar.)

a. Calculate the present value of total outflows.

Total outflows           $

b. Calculate the present value of total inflows.

Total inflows           $

c. Calculate the net present value.

Net present value           $

d. Should the old issue be refunded with new debt?

  

• Yes

• No

Answer 1

Solution:

After tax discout rate=13.30%(1-0.40)=8%

a)Calculation of Present value of outflows

i)Call Premium on old bond

=$20,000,000*9%=$1800,000

After tax call premium=$1800,000(1-0.40)=$1080,000

ii)Underwriting cost of new issue

Per year tax saving on underwriting cost=($550,000/20)0.40

=$11000

Present value of Actual cash outlows=$550,000-Present value of tax saving

=$550,000-($11000*PVAF for 16 years at 8%)

=$550,000-$11000*8.8514

=$452,634.60

Thus total present value of cash outflows=$452,634.60+$1080,000

=$1532,634.60

b) Calculation of present value of total inflows

i)Cost saving due to lower interest rate

Interest on old bond=$20,000,000*16%=3200,000

Interest on new bond=$20,000,000*13.30%=$2660,000

After taxSaving per year=($3200,000-$2660,000)(1-0.40)

=$324,000

Present value of tax saving=$324,000*8.8514

=$2867,853.60

ii)Underwriting cost on old issue

Underwriting cost=$400,000

Unamortized portion of Underwriting cost=$400,000-($400,000/20)*4

=$320,000

Present value of annual unamortized underwriting cost=$20,000*8.8514

=$177028

Immediate benefit dure to old underwriting cost write off=$320,000-$177028

=$142,972

tax benefit=$142972(0.40)=$57188.80

Thus ,present value of total inflows is

=$57,188.80+$2867,853.60

=$2925,042.40

c)NPV=present value of total inflows- present value of total outflows

=$2925,042.40-$1532,634.60

=$1392,407.80

since the NPV is positive,hence old issue should be refunded with new debt.Thus answer is Yes.