Question

Providence Industries has an outstanding debenture of $25 million that was issued when flotation costs could be expensed immediately. It carries a coupon rate of 10 percent and has 15 years to maturity. Currently, similar risk bonds are yielding 9 percent over a 15-year period, and Providence is wondering if a refunding would be economically sound. The existing debenture has a call premium of 5 percent at present. It is estimated that a new issue would require underwriting costs of $470,000 and other costs of $80,000. No overlap period would be required. Providence Industries has a tax rate of 25 percent. Its cost of capital is 16 percent. a-1. Compute the discount rate. (Round the final answer to 2 decimal places.) Discount rate % a-2. Calculate the present value of total outflows. (Round "PV Factor" to 4 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar.) Total outflows $ a-3. Calculate the present value of total inflows. (Round "PV Factor" to 4 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar.) Total inflows $ a-4. Calculate the net present value. (Round "PV Factor" to 4 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar.) Net present value $ a-5. Should Providence Industries refund the old issue? Yes No

Answer 1

Solution:

a-1: Discount rate = Rate*(1 - tax rate)

Discount rate = 9%*(1 - 0.25)

Discount rate = 6.75%

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a-2: Costs (Outflows)

1. Payment of call premium: $2,500,000 x 5% = $1,250,000

2. Borrowing expenses of new issue:

Underwriting cost = $470,000

Other costs = $80,000

Total borrowing costs = $470,000 + $80,000 = $550,000

Amortization of expenses = $550,000/5*0.25 = $27,500 tax savings per year

Actual expenditure = $550,000

PV of future tax savings = $27,500 x (PVIFA @ i = 6.75%, 5)*

PV of future tax savings = $113,514

Net cost of borrowing expenses of new issue = $436,486

PVIFA @ i = 6.75%, 5 = [(1.0675^5-1)/(0.0675*1.0675^5)]

= 4.1278

3. No overlap period

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a-3: Benefits (Inflows)

4. Cost savings in lower interest rates:

10% (interest on old bond) x $25,000,000 = $2,500,000

9% (interest on new bond) x $25,000,000 = $2,250,000

Savings per year

After tax savings per year $250,000 x (1 -0.25) = $187,500

PV of annual aftertax interest savings

$187,500 PVIFA @ 6.75%, 15 = $1,735,030

PVIFA @ 6.75%, 15 = [(1.0675^15-1)/(0.0675*1.0675^15)]

PVIFA @ 6.75%, 15 = 9.2535

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a-4: The Net Present Value (NPV) is calculated as follows:-

NPV = PV of outflows + PV of inflows

NPV = -$1,250,000 - $436,486 + $1,735,030

NPV = $48,544

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a-5: Since the NPV is positive, Providence industries should refund the issue.