3 Part Question: Dairy Corp. has a $10 million bond obligation outstanding which
ID: 2637966 • Letter: 3
Question
3 Part Question: Dairy Corp. has a $10 million bond obligation outstanding which it is considering refunding. The bonds were issued at 10% and the interest rates on similar bonds have declined to 8%. The bonds have five years of their 20-year maturity remaining. The new bond will have a 5-year maturity. Dairy will pay a call premium of 5% and will incur new underwriting costs of $400,000 immediately. There is no underwriting cost consideration on the old bond. The company is in a 40% tax bracket. To analyze the refunding decision, use a 6% discount rate.
What is the present value of the cash outflows related to the call premium and underwriting cost?
Round to the nearest dollar and omit commas and dollar signs (example: $25,000 would be entered as 25000).
What is the present value of the cash inflows related to the refunding decision?
Round to the nearest dollar and omit commas and dollar signs (example: $25,000 would be entered as 25000).
Should Dairy Corp. refund the old bond issue and replace it with the new issue?
Explanation / Answer
Given:
Original tenor of the old bond= 20 years
Remaining life of the old bond= 5 years
Tenor of the new bond= 5 years
Discount rate= 6%
Amount of bond= $10,000,000
Old Interest rate= 10.00%
New Interest Rate= 8.00%
Call premium= 5%
Underwriting Cost on old issue= $0
Underwriting Cost on new issue= $400,000
Tax rate= 40%
Present value of the cash outflows related to the call premium and underwriting cost:
Outflows:
1) After tax cost of call premium= $300,000 =5.% x $10,000,000. x (1-0.4)
2) Underwriting cost for new issue:
Total underwriting cost= $400,000
Number of years= 5 years
Expense (for tax purpose) underwriting cost= $80,000 per year =$400,000. / 5
Tax shield from underwriting expense= $32,000 =40.% x $80,000.
Present Value of Tax shield of underwriting expense:
n= 5
r= 6.00%
PVIFA (5 periods, 6.% rate ) = 4.212364
Annuity= $32,000
Therefore, present value= $134,796 =32000x4.212364
Therefore, net after tax underwriting cost= $265,204 =$400,000. - $134,796.
Total Outflow= $565,204 =$300,000. + $265,204.
answer = -$565,204
Present value of the cash inflows:
Inflows:
n= 5 years
r= 6.00%
PVIFA (5 periods, 6.% rate ) = 4.212364
1) After tax saving in interest:
Present Value of Cash cost saving less tax benefits= $505,484 =$10,000,000.x (10.% - 8.% ) x (1-0.4) x4.212364
Answer = $505,484
Since the Net After-tax savings on paying off the old issue and making the new issue is lower than the cash outflows related to the call premium and underwriting cost, we should not refund.
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