Question

Oklahoma Service Company is contemplat­ing offering a new $150 million bond issue to replace an outstanding $150 million bond issue to take advantage of a recent decline in inter­est rates. The old and new bonds are described below. The firm is in the 35 percent tax bracket.

Old bonds The outstanding bonds have a $1,000 par value and a 7.0 percent coupon interest rate. They were issued 5 years ago with a 15-year maturity.  They were initially sold for their par value of $1,000, and the firm incurred $500,000 in flotation costs. They are callable at $1,070.

New bondsThe new bonds would have a $1,000 par value and a 5.7 percent coupon interest rate. They would have a 10-year maturity and could be sold at their par value. The flotation cost of the new bonds would be $750,000. The firm does not expect to have any overlapping interest.

a.         Determine the initial investment required to call the old bonds and issue the new bonds.

b.         Calculate the annual cash flow savings, if any, that are expected from the proposed bond-refunding decision.

c.         If the firm has a 4.0 percent average after-tax cost of debt, find the net present value (NPV) of the bond-refunding decision. Would you recommend the proposed refunding? Why or why not?

Answer 1

A. The initial investment required to call the old bond = No. of Bonds x Callable Value + Floatation costs = 150,000 bonds x $ 1070 + $ 750,000 = $ 161,250,000

B. Annual cash flow savings = 150,000 bonds (Company planning to issue $ 150 Mn. bonds at par to replace old debt) X (7% - 5.7%) = $ 1,950,000

Tax breaks lost due to lower interest rate = $ 1,950,000 X 35% = $ 682,500

Net Annual savings = $ 1,267,500

C.

Year	Annual savings (post tax)	Discounted savings @ 4%
Year 1	1,267,500	1,218,750
Year 2	1,267,500	1,171,875
Year 3	1,267,500	1,126,803
Year 4	1,267,500	1,083,464
Year 5	1,267,500	1,041,793
Year 6	1,267,500	1,001,724
Year 7	1,267,500	963,196
Year 8	1,267,500	926,150
Year 9	1,267,500	890,529
Year 10	1,267,500	856,278
		10,280,560

Hence, the refunding option results in a cumulative savings of $ 10,280,560 over 10 years. However, it results in a payment of one-time premium through calling the existing bonds amounting to $ 10,500,000 as well as $ 750,000 in floatation costs. Hence, the refunding exercise is onerous to the extent of ($ 10,500,000 + $ 750,000 - $ 10,280,560) = $ 969,440. Hence, the proposed refunding exercise is not advisable.