Question

The Robinson Corporation has $27 million of bonds outstanding that were issued at a coupon rate of 10.950 percent seven years ago. Interest rates have fallen to 10.250 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 2.70 percent of the total bond value. The underwriting cost on the new issue will be 1.80 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a call premium of 6 percent 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

a) Discount Rate = Interest rate x (1 - tax rate)
Discount Rate = 10.250% * (1 - 30%) = 7.17%	7.00%
b)
Present value of Outflows includes Payment on call provision and Underwriting cost on new issue
1) Payment on call provision
6th year call premium	6.00%
Less : 1/2 % each year	0.50%
Call premium in the 7th year	5.50%
After tax Payment of call Provision =$27,000,000 x 5.50% x (1-30%)	$1,039,500
2) Underwriting cost on new issue
Actual expenditure 1.8% × $27,000,000	$486,000
Amortization of costs ($486,000/17 years)	$28,588.24
Tax savings per year = ($28,588.24 X 30%)	$8,576.47
Actual expenditure	$486,000
PV of future tax savings $8576.47 x PVIFA(7%,17)
PV of future tax savings $8576.47 x 9.763	$83,733.99
Net cost of underwriting expense on new issue	$569,733.99
Present value of outflows = $1,039,500 + $569,733.99	$1,609,233.99
PVIFA (6%,17) Appendix D	$9.763
c)
Present value of inflows include Cost savings in lower interest rates and Underwriting cost on old issue
1) Cost savings in lower interest rates
Interest on old bond = 10.950% x $27,000,000	$2,956,500
Interest on New bond = 10.250% x $27,000,000	$2,767,500
Savings per year	$189,000
After tax savings = $189,000 x (1-30%)	$132,300
Present value of savings = $132,300 x PVIFA(7%,17)	$1,291,674.4
2) Underwriting cost on old issue
Original amount (2.70% × $27,000,000)	$729,000
Less: Amount written off over last 7 years at = $841,000/24 years x 7 years	$212,625
Unamortized old underwriting cost	$516,375
Less: Present value of deferred future write off = $729,000/24 x PVifa (7%,17)	$296,557.9
Immediate gain in old underwriting write-off	$219,817.1
Aftertax value of immediate gain in old underwriting cost write-off ($253,596.54 x 30%)	$65,945.13
Present value of inflows = $1,291,674.4 +65,945.13	$1,357,619.53
d) Net present Value
Present value of inflows = $1,291,674.4 +65,945.13	$1,357,619.53
Present value of outflows = $1,039,500 + $569,733.99	$1,609,233.99
Net Present Value	-$251,614.46