The Robinson Corporation has $42 million of bonds outstanding that were issued a
ID: 1171107 • Letter: T
Question
The Robinson Corporation has $42 million of bonds outstanding that were issued at a coupon rate of 12.450 percent seven years ago. Interest rates have fallen to 11.450 percent. Mr. Brooks, the Vice-President of Finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 4.20 percent of the total bond value. The underwriting cost on the new issue will be 2.60 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a call premium of 7 percent starting in the sixth year and scheduled to decline by one-half percent each year thereafter. (Consider the bond to be seven years old for purposes of computing the premium.) Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole percent (e.g. 4.06 percent should be rounded up to 5 percent).
Compute the discount rate. (Do not round intermediate calculations. Input your answer as a percent rounded up to the nearest whole percent.)
Calculate the present value of total outflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)
Calculate the present value of total inflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)
Calculate the net present value. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)
Net present value
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The Robinson Corporation has $42 million of bonds outstanding that were issued at a coupon rate of 12.450 percent seven years ago. Interest rates have fallen to 11.450 percent. Mr. Brooks, the Vice-President of Finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 4.20 percent of the total bond value. The underwriting cost on the new issue will be 2.60 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a call premium of 7 percent starting in the sixth year and scheduled to decline by one-half percent each year thereafter. (Consider the bond to be seven years old for purposes of computing the premium.) Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole percent (e.g. 4.06 percent should be rounded up to 5 percent).
Explanation / Answer
Coupon Rate 12.45 Rate fallen 11.45 Years to maturity 17 Yrs Tax rate 30% Underwriting cost old issue 4.20% Underwriting cost new issue 2.60% original bond indenture starting from 6th year 7% Decline by 0.5% a) Discount rate is equal to aftertax cost of new debt Discount rate = 11.45%*(1-0.30) 11.45%*0.70 0.08015 Discount rate = 0.08015 to be rounded to the nearest whole number = 9.00% b) Calculate the total outflows 1 Underwriting cost on new issue Underwriting cost = 2.60%*42000000 $1092000 Amortization of costs during the bond period (1092000/17) $64235.29 Tax Savings per year @ 30% = $64235.29*0.30 $19270.59 Present value of underwriting cost Actual Expenditure $1092000 Less: PV of tax savings $19270.59*8.5436 $164640.20 PV taken from appendix D N=17, I = 9% Net cost of underwriting $927359.80 2 Call Provision payment(Call premium on 7th year = 6.50% $42000000*6.50% $2730000 Less : Tax on Call provision $819000 Call provision payment after tax cost $1911000 b) Calculate the total inflows Cost savings due to lower interest rate 42000000*(12.450%-11.450%) $420000 Less: Tax @ 30% $126000 Aftertax cost savings $294000 Present value of cashflows = 294000*8.5436 $2511818.4 Underwriting cost of old issue 42000000*4.50% $1890000 Amount written off over 7 yrs (1890000*7/24) $551250 $78750 per yr Unamortised old cost $1338750 Less : Present value of future write off $78750*8.5436 $672808.50 Gain on old under writing write off $665941.50 Tax on $665941.50*30% $199782.50 Cash Inflows Savings on Interest $2511818.4 Gain on underwriting $199782.50 Total Cash inflows $2711601 Cash outflows Underwriting costs $927359.80 Call provision payment $1911000 Total Cash outflows $2838359.80 Net Present Value $(126758.80)
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