Chapter 14 Long-Term Liabilities: Bonds and Notes71z CP 14-3 Communication Nordb
ID: 2530918 • Letter: C
Question
Chapter 14 Long-Term Liabilities: Bonds and Notes71z CP 14-3 Communication Nordbock Inc. reports the following outstanding bond issue on its December 31, 20Y1, balance sheet: $1,000,000, 796, 10-year bonds that pay interest semiannually. The bonds have been outstanding for five years and were originally issued at face amount. The company is considering redeeming these bonds on January 1, 20Y2, at 103 and is- suing new $1,000,000, 596, five-year bonds at their face amount. These bonds would pay interest semiannually on June 30 and December 31. Write a brief memo to Liz Nolan, the chief financial officer, discussing the costs of redeeming the existing bonds, the proceeds from issuing the new bonds, and whether this is a good financial decision.Explanation / Answer
Considering that the original bonds were issued at Face Value, it is asssumed that there is no Discount and Premium to be Amortized.
Option A
The cost of redeeming the existing bonds would be (103-100) X 1,000,000/100 = $30,000
The Company would also incur interst cost on the new bonds over the next five years amounting to:
5% X 1,000,000 X 5 years = 250,000
The Total cost of this option would be the Present Value of 250,000 plus $30,000
Option B
If the Company Continues to use the existing bonds, the interest expense it would incur would be:
1,000,000 X 7% X 5 years = $350,000
The cost of this option would be the PV of the $350,000 interest cost.
In a direct Comparison, Option A seems to be the more benefitial one if we ignore time value of money. However, there is an upfront cost of $30,000 involved. Company would need to judge whether the difference in PV of interest costs is sufficient for the company to recover the upfront premium cost of $30,000.
For example, lets consider that the Company's required rate of return is 10%.
Cost under Option A would $30,000 + 189,539 = $219,539
Cost under Option B = $265,355
Hence the Company would Save 45,816 in costs by redeeming the bond and issuing new 5% ones. However this decision would ultimately depend upon the Company's implicit rate of interest.
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