Question

In: Accounting

NARRBEGIN: Loose Cannon refunding Loose Cannon Co. Loose Cannon Co. is evaluating a new $75 million...

NARRBEGIN: Loose Cannon refunding

Loose Cannon Co.

Loose Cannon Co. is evaluating a new $75 million bond issue, the proceeds of which would be used to call and retire its outstanding $75 million bonds. Details on both bond issues are presented below. The firm is in the 35% tax bracket.

Old Bonds The old issue sold at par, with a coupon rate of 11 percent. It was issued five years ago with a twenty year maturity. The issue had $350,000 in flotation costs and carries a call price of $1150.

New Bonds The new issue are expected to sell at par with an 8.5 percent coupon rate and a 15 year maturity. Flotation costs are forecast to be $500,000. Interest payments will overlap for 2 months while the old bonds are retired.

NARREND

Refer to Loose Cannon Co. What is the initial investment required to refund the bonds?

a.

$11,250,000

b.

$8,614,375

c.

$7,312,500

d.

$3,937,500

ANS: B   

Refer to Loose Cannon Co. What are the annual cash flows associated with the new bonds?

a.

$4,143,750

b.

$6,375,000

c.

$4,132,083

d.

$6,357,051

ANS: C                                              

Refer to Loose Cannon Co. What is the NPV of the refunding decision?

a.

$3,654,164

b.

$5,356,375

c.

$1,224,292

d.

$8,614,375

ANS: A                      

Solutions

Expert Solution

1. Calculation of initial investment required to refund the bonds :

Particulars Amount ($)
Cash Outflow on redemption of old bonds (750,00,000 * 1150 / 1000) 8,62,50,000
Less : Cash Inflow on New bond issue (7,50,00,000)
Less : Call Premium Tax Shield (1,12,50,000 * 35%) (39,37,500)
Less : Tax shied on unamortised floatation cost of old bonds (3,50,000 / 20 * 15 * 35%) (91,875)
Add : New bonds floatation cost 5,00,000
Add : Overlapping Interest [(7,50,00,000 * 11 % * 2 / 12) -35%] 8,93,750
Initial Investment 8,614,375

Hence , Option B is correct.

2. Calculation of annual cash flows associated with new bonds :

Particulars Amount ($)
Annual Coupon on new bonds (net of tax shield) [(7,50,00,000 * 8.5%) -35%] 41,43,750
Less : Annual Tax benefit on amortization of floatation cost (5,00,000 / 15 * 35%) (11,667)
Annual cash flows associated with new bonds 4,132,083

Hence , Option C is correct.

3. Calculation of NPV of bond refunding decision :

NPV = Present Value of Cash inflows - Initial Outflow

= 12,268,539 - 8,614,375

= $ 3,654,164

Hence, Option A is correct.

ekkarill92 answered 1 year ago
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