Question

In: Finance

The Bowman Corporation has a bond obligation of $25 million outstanding, which it is considering refunding....

The Bowman Corporation has a bond obligation of $25 million outstanding, which it is considering refunding. Though the bonds were initially issued at 10 percent, the interest rates on similar issues have declined to 8.7 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 9 percent on the old issue. The underwriting cost on the new $25,000,000 issue is $550,000, and the underwriting cost on the old issue was $440,000. The company is in a 35 percent tax bracket, and it will use an 11 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.(Do not round intermediate calculations and round your answer to 2 decimal places.)
  


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


c. 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.)
  


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

Yes
No

Solutions

Expert Solution

Call Premium on old issue = 9% * 25 million = 2.25 million

After tax = 2.25 * (1-35%) = 1,462,500

Underwirting cost of new issue = 550,000 or 55000 per annum and tax savings = 55000 *35% = 19250

This is like an annuity and the present value of this annuity at 11% discount rate will be :

PV = 19250 * [1-(1+11%)-10]/11% = 113,367.7

Hence the net undewriting outflow in PV terms = 550000-113367.7 = 436,632.3

Thus total PV of outflows = 436632.3 + 1462500 = 1,899,132.28

Now we move to inflows:

Savings from reduced rates = 25000000 * (10%-8.7%) = 325000 annually

Taxes on these savings (loss of tax shield) = 325000 * 35% = 113750

Hence net savings per annum = 211250 and this like an annuity for 10 years to be discounted at 115 to arrive at the PV. Hence the PV = 211250 * [1-(1+11%)-10]/11% = 1,244,100.26

Now the underwiritng cost of old debt = 440000 and this was to be amortised over 20 years . With residual 10 years left, the amount to be amortised is 220000 or annually 22000. The PV of this annuity stream will be 22000 * [1-(1+11%)-10]/11% =129563.10

The net difference in PV terms for old amortisation = 220000-129563.10 = 90436.9

The taxes on this amount will be = 90436.9 * 35% = 31652.91

Thus total PV of inflows = 31652.91 + 1244100.26 = 1,275,753.17

NPV = 1275753.17 - 1899132.28 = -623379.11

Since the NPV is negative, this refund should not be carried out.


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