Question

The Wagner Corporation has a $24 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 11 percent, the interest rates on similar issues have declined to 8.6 percent. The bonds were originally issued for 25 years and have 21 years remaining. The new issue would be for 21 years. There is a 8 percent call premium on the old issue. The underwriting cost on the new $24 million issue is $590,000, and the underwriting cost on the old issue was $440,000. The company is in a 30 percent tax bracket, and it will allow an overlap period of one month (1/12 of the year). Treasury bills currently yield 3 percent. (Do not round intermediate calculations. Enter the answers in whole dollars, not in millions. Round the final answers to nearest whole dollar.) a. Calculate the present value of total outflows. Total outflows $ b. Calculate the present value of total inflows. Total inflows $ c. Calculate the net present value. Net present value $ d. Should the old issue be refunded with new debt? Yes No

Answer 1

NPV for bond refunding

PV of annual cash flow savings(W.No.2)

(4,06,348*PVIFA6.02%,21)i.e.11.74 47,70,525

Less:Initial Investment (W.N.1) 19,77,120

NPV 27,93,405

Working notes:

1.Initial Investment

(a) Call premium2,40,00,000*8%=19,20,000

Less Tax@30% =5,76,000

13,44,000

(b) Flotation Cost 5,90,000

(c) Overlapping Interest

Before tax (2,40,00,000*11%*1/12)=2,20,000

Less:Tax@30% = 66,000

1,54,000

(d) Tax saving on unamortised flotation cost 4,40,000*21/25*0.3=(1,10,880)

Initial Investment 19,77,120

(2) Annualcash flow savings

(a) Old bond

(i) Interest Cost (2,40,00,000*11%)*70% 18,48,000

Taxsaving from amortisation of flotation cost 4,40,000/25*30% (5,280)

Annual after tax cost payment under old bond (A)     18,42,720

(b) New bond

(i) Interest Cost (2,40,00,000*8.6%)*70% 14,44,800

Taxsaving from amortisation of flotation cost 5,90,000/21*30% (8,428)

Annual after tax cost payment under old bond (B)     14,36,372

Annual Cash Flow Saving (A)-(B) 4,06,348

Refundingof bond is recommended as NPV is positive