Capital Structure Decision Chapter 20. Ch 20-06 Build a Model Note: Fill in the
ID: 2626120 • Letter: C
Question
Capital Structure Decision
Chapter 20. Ch 20-06 Build a Model Note: 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
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 = $ 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 = $ 81,818.18 Total amortization tax effects = $ 9,090.91 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 = $ 8,49,090.91 After-tax cost of new debt = 6.00% NPV of refunding decision = $ 31,21,585.83 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 = 8.565%
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.