Question

The Robinson Corporation has $43 million of bonds outstanding that were issued at a coupon rate of 12.550 percent seven years ago. Interest rates have fallen to 11.750 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 4.30 percent of the total bond value. The underwriting cost on the new issue will be 2.60 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)

Answer 1

	IF THE OLD BONDS ARE RETIRED
		Bond value	$43,000,000
		Additional expenses:
		Call premium(6-1.5)=4.5%	$               1,935,000	($43 million*0.045)
		Underwriting cost(2.6%)	$1,118,000	($43 million*0.026)
		Total initial cost	$               3,053,000
		Tax Rate=30%	0.3
		Before tax cost of new debt	11.75%
		After tax cost of new debt	8.225	(11.75*(1-0.3))
		Discount rate	9%
		Annual Coupon payment for old bond	$5,396,500	($43million*0.1255)
		Annual Coupon payment for NEW bond	$5,052,500	($43million*0.1175)
		Annual Savings in Coupon payment	$344,000
		Present Value(PV) of cash flow=(Cash flow)/((1+i)^N)
		i=discount rate=9%=0.09
		N=Year of cash flow
		Yearwise cash flow and PV of cash flows are given below:
		N	A	B=A/(1.09^N)
		Year	Cash flow	PV of cash flow
		0	$             (3,053,000)	-3053000
		1	$344,000	315596.3303
		2	$344,000	289537.9177
		3	$344,000	265631.1171
		4	$344,000	243698.2726
		5	$344,000	223576.3969
		6	$344,000	205115.9604
		7	$344,000	188179.7802
		8	$344,000	172642.0002
		9	$344,000	158387.1562
		10	$344,000	145309.3176
		11	$344,000	133311.3005
		12	$344,000	122303.9454
		13	$344,000	112205.4545
		14	$344,000	102940.784
		15	$344,000	94441.08621
		16	$344,000	86643.19836
		17	$344,000	79489.17281
			TOTAL	-113990.809
		Internal Rate of Return		(Using IRR function over cash flow)
		Net Present Value(NPV)	$          (113,990.81)
		Net Present value is negative , hence it is NOT recommended