Question

Alberta Sand Oil Ltd. has $30 million 16% per annum bonds outstanding. These bonds were issued 5 years ago for a term of 20 years. They were sold at par at the time of their offering and they can be called at a call premium of 14%. The firm can now sell a new $30 million bond issue at par, with 12% interest per annum and a term to maturity of 15 years. Flotation costs of $2 million are expected in the sale of the new issue. Assume that flotation costs are tax deductible in the year that they are incurred. An overlap period of 2 months is anticipated during which the proceeds of the new bonds can be invested in short-term securities yielding 8% per annum. The firm’s corporate tax rate is 50%.

a) Should the firm refund the old bond issue?

b) Consider the same problem as given in question 1 above but now assume that for tax purpose flotation costs of the bond are amortized in equal amounts over the next five years. Redo refunding decision.

c) Consider the same data as in the two questions above. Now assume that the old bonds were sold at a 5% discount of the face value. Re-evaluate refunding.

Answer 1