Question

Bond Redemption Decision

Armstrong Aero Ace, a flight training school, issued $100,000 of 20-year bonds at face value when the market rate was 10%. The bonds have been outstanding for ten years. The company pays annual interest on January 1. The current rate for similar bonds is 4%. On January 1, the controller would like to retire the bonds at 102 and then issue $100,000 of ten-year bonds to pay 4% annual interest.

Required:

Complete the memo to the controller advising him to retire the outstanding bonds and issue new debt. Ignore taxes.

TO: Controller
RE: Retirement of Outstanding Bonds
The outstanding bonds require the company to continue to pay % in a market that requires only a % return. If the company issues new bonds at 4%, the new issuance will yield the company $100,000 and the interest cash payment will be much at % than at the old rate of %. The benefit to the company is that in the future ten years, the company is required to pay only $ each year rather than $ in annual interest. Discounting the savings of $ per year yields a benefit to the company of . This is than the call premium of 2% and the retirement of the original bonds. Therefore, I that the company retire the outstanding bonds and reissue the bonds at the lower rate in order to reduce future cash outflow.

Answer 1

Soluiton:

Current annual interest = $100,000 * 10% = $10,000

Annual interest when new bond issued = $100,000 * 4% = $4,000

Annual saving of interest = $10,000 - $4,000 = $6,000

Present value of saving at current rate of interest = $6,000 * Cumulative PV Factor at 4% for 10 periods

= $6,000 * 8.110896 = $48,665

TO: Controller

RE: Retirement of Outstanding Bonds

The outstanding bonds require the company to continue to pay 10% in a market that requires only a 4% return. If the company issues new bonds at 4%, the new issuance will yield the company $100,000 and the interest cash payment will be much lower at 4% than at the old rate of 10%. The benefit to the company is that in the future ten years, the company is required to pay only $4,000 ($100,000 * 4%) each year rather than $10,000 ($100,000*10%) in annual interest. Discounting the savings of $6,000 ($10,000 - $4,000) per year yields a benefit to the company of $48,665. This is higher than the call premium of 2% and the retirement of the original bonds. Therefore, I recommend that the company retire the outstanding bonds and reissue the bonds at the lower rate in order to reduce future cash outflow.