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

Solution:

a) Determining the discount rate
Total Bonds outstanding (in Million)	39
Coupon rate (At the time of issue of bond)	12.15
Coupon rate (Currently)	11.15
Remainning time to maturity	17 Years
Tax rate	30%
Underwritting cost of old issue (% of old Total bond value)	3.90%
Underwritting cost of new issue (% of new Total bond value)	2.40%
Underwritting cost (in Millions) = Total Current outstanding*Underwritting cost of new issue in %
Underwritting cost (in Millions) = 39 *2.4%
Underwritting cost (in Millions) = 0.936
Cost of debt before tax = (39*11.15%)/(39-0.936)
Cost of debt before tax = 0.1142 i.e. 11.42%
Cost of debt after tax = Cost of tax before tax*(1-Tax rate)
Cost of debt after tax = 11.42%*(1-30%)
Cost of debt after tax = 0.07994 i.e. 7.99%
Discount rate = 8% (Based on value of cost debt determined above)
b) Determining the present value of total outflows
Present Value of total Outflows:
Actual Expenditure (39 *2.4%) (In Million)	$                                      0.94
Amortization of costs per year (In Million)	$                                      0.06
Tax Savings per year@30%	$                                      0.02
Actual Expenditure	$                                      0.94
PV of future tax savings (0.01652*9.122)	$                                      0.15
Net cost of underwritting expense of new issue (In Million)	$                                      0.79
c) Determining the present value of total inflow
Cost saving in lower interest rates
Interest on old bond (39*12.15%) In Millions	$                                      4.74
Interest on new bond (39*11.15%) In Millions	$                                      4.35
Savings Per year (In Millions)	$                                      0.39
Savings Per year after tax (0.39*(1-0.30)) (In Millions)	$                                      0.27
Present value of total inflow (in Millions) (0.27*9.122)	$                                      2.46
d) Determining the NPV
NPV = Cost Savings in lower interest rate + Underwritting cost of old issue - Payment on Call Provision - Underwritting cost of new issue
Cost Savings in lower interest rate (in Million)	$                                      2.46
Underwritting cost old issue (in Million)	$                                      0.40
Payment on Call Provision (in Million)	$                                      2.73
Underwritting cost of new issue (in Million)	$                                      0.79
NPV	$                                   (0.65)