Capital Structure Decision Chapter 20. Ch 20-06 Build a Model Note: Fill in the
ID: 2621522 • Letter: C
Question
Capital Structure Decision
Chapter 20. Ch 20-06 Build a ModelNote: Fill in the shaded cells with the appropriate formula
Schumann Shoe Manufacturer is considering whether or not to refund a $70 million, 10% coupon, 30-year bond issue that was sold 8 years ago. It is amortizing $4.5 million of flotation costs on the 10% bonds over the issue's 30-year life. Schumann's investment bankers have indicated that the company could sell a new 22-year issue at an interest rate of 8 percent in today's market. Neither they nor Schumann's management anticipate that interest rates will fall below 6 percent any time soon, but there is a chance that interest rates will increase.
A call premium of 10 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Schumann's marginal federal-plus-state tax rate is 40 percent. The new bonds would be issued 1 month before the old bonds are called, with the proceeds being invested in short-term government securities returning 5 percent annually during the interim period.
Current bond issue data
Par value
$ 70,000,000
Coupon rate
10%
Original maturity
30
Remaining maturity
22
Original flotation costs
$ 4,500,000
Call premium
10%
Tax rate
40%
Refunding data
Coupon rate
8.0000%
Maturity
22
Flotation costs
$ 5,000,000
Time between issuing new bonds and calling old bonds (months) 1
Rate earned on proceeds of new bonds before calling old bonds (annual) 5%
a. Perform a complete bond refunding analysis. What is the bond refunding's NPV?
Initial investment outlay to refund old issue:
Call premium on old issue =
After-tax call premium =
New flotation cost =
Old flotation costs already expensed =
Remaining flotation costs to expense =
Tax savings from old flotation costs = You get to expense the remaining flotation costs
Additional interest on old issue after tax = This is interest paid on the old bond issue between when the new bonds are issued and the old bonds are retired Interest earned on investment in T-bonds after tax = This is interest earned on the proceeds from the new bonds before they are used to pay off the old bonds.
Total investment outlay =
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation =
Tax savings lost on old flotation =
Total amortization tax effects =
Annual interest savings due to refunding:
Annual after tax interest on old bond =
Annual after tax interest on new bond =
Net after tax interest savings =
Annual cash flows =
After-tax cost of new debt =
NPV of refunding decision =
b. At what interest rate on the new debt is the NPV of the refunding no longer positive?
Use Goal Seek to set cell D60 to zero by changing cell C27.
"Break-even" interest rate =
Explanation / Answer
Part A:
Call premium on old issue =
$ 70,00,000.00 After-tax call premium =
$ 42,00,000.00 New flotation cost =
$ 50,00,000.00 Old flotation costs already expensed = $ 12,00,000.00 Remaining flotation costs to expense = $ 33,00,000.00 Tax savings from old flotation costs = $ 13,20,000.00 Additional interest on old issue after tax = $ 3,50,000.00 Interest earned on investment in T-bonds after tax = $ 1,75,000.00 Total investment outlay =
$ 80,55,000.00
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation = $ 90,909.09 Tax savings lost on old flotation = $ 60,000.00 Total amortization tax effects =
$ 30,909.09
Annual interest savings due to refunding:
Annual after tax interest on old bond = $ 42,00,000.00 Annual after tax interest on new bond = $ 33,60,000.00 Net after tax interest savings =
$ 8,40,000.00
Annual cash flows =
$ 8,70,909.09
NPV of refunding decision =
$ 34,08,778.61
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