Question

The Robinson Corporation has $39 million of bonds outstanding that were issued at a coupon rate of 12.150 percent seven years ago. Interest rates have fallen to 11.150 percent. Mr. Brooks, the Vice-President of Finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 3.90 percent of the total bond value. The underwriting cost on the new issue will be 2.40 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a 9 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter. (Consider the bond to be seven years old for purposes of computing the premium.) Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole percent (e.g. 4.06 percent should be rounded up to 5 percent).

a. Compute the discount rate. (Do not round intermediate calculations. Input your answer as a percent rounded up to the nearest whole percent.)
  

b. Calculate the present value of total outflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)
  

c. Calculate the present value of total inflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)
   

d. Calculate the net present value. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)
  

Answer 1

		Discount Rate =After Tax cost of new debt
		Interest rate for the new Bond	11.150%
		Underwriting cost of new Bond as percentage	2.40%
		Before tax cost of new debt=11.150/(1-0.0240)=	11.42%
		Tax Rate =30%
		After tax cost of new debt =11.42*(1-0.3)	8.00%
	a	DISCOUNT RATE	8.0%
	b	Present Value (PV) of total outflows:
		Investment Outlay:
		Call Premium on old bond=(9-0.5)=8.5%
		Before tax Call Premium paid on old bond=$39million*8.5%	($3,315,000)
	E	After tax Call Premium paid on old bond=3315000*(1-0.30)	($2,320,500)
	B	Underwriting cost on new bond=$39 million*2.4%	($936,000)
		Underwriting cost incurred on old bond=$39million*3.9%	$1,521,000
		Number of years to maturity of old Bond	24							6
		Annual amortization=1521000/24	$63,375
		Unamortized underwriting cost =63375*17=	$1,077,375
	F	immediate tax saving on unamortized underwriting cost =1077375*0.3	$323,213
	G=E+B+F	Present Value (PV) of total Cash Outflow	($2,933,288)
	c	Present Value of total inflows
		Annual Tax Shield on amortization expense of underwriting cost (New Bond)	$16,518	(936000/17)*30%
		Tax Shield lost on amortization expense of underwriting cost Old Bond)	($19,013)	(63375*30%)
	H	Net annual tax shield on amortization cost of underwriting expenses	($2,495)
		After tax interest savings on old issue=$39million*12.150%*(1-0.3)	$3,316,950
		After tax interest cost on new bond=$39million*11.150%*(1-0.3)	($3,043,950)
	I	Net annual interest savings	$273,000
	Pmt=H+I	Net Annual Cash inflows	$270,505
	Rate=STEP1	Discount Rate	8.0%
	Nper	Number of Years	17
	PV	Present Value (PV)of total inflows	$2,467,450	(Using PV function of excel with Rate=8%, Nper=17, Pmt=-270505)
	d	NET PRESENT VALUE
	NPV=PV+G	Net Present Value =2467450-2933288=	($465,837.44)