The Bowman Corporation has a bond obligation of $14 million outstanding, which i

Question

The Bowman Corporation has a bond obligation of $14 million outstanding, which it is considering refunding. Though the bonds were initially issued at 11 percent, the interest rates on similar issues have declined to 9.8 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a call premium of 7 percent on the old issue. The underwriting cost on the new $14,000,000 issue is $440,000, and the underwriting cost on the old issue was $330,000. The company is in a 35 percent tax bracket, and it will use an 12 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision. Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

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.)

Calculate the present value of total outflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)

Explanation / Answer

Given,

Original tenor of the old bond= 20 years
Remaining life of the old bond= 10 years
Tenor of the new bond= 10 years
Discount rate= 12%
Amount of bond= $14,000,000
Old Interest rate= 11.00%
New Interest Rate= 9.80%
Call premium= 7%
Underwriting Cost on old issue= $330,000
Underwriting Cost on new issue= $440,000
Tax rate= 35%

a) OUTFLOW
After tax cost of call premium= 7% x $14,000,000. x (1 - 35%) = $637,000

Underwriting cost for new issue:
Total underwriting cost= $440,000
Number of years= 10 years
Expense (for tax purpose) underwriting cost= $440,000 / 10 = $44,000
Tax shield from underwriting expense= 35% x $44,000 = $15,400

Present Value of Tax shield of  underwriting expense:
n= 5
r= 6.00%

Annuity= $15,400 (as calculated above)
Therefore, present  value= PV(12%, 10 years, $15,400) = $87,013.43 (Excel formula for present value used)

Therefore, net after tax underwriting cost= $440,000. - $87,013.43 = $352,986.57

PV of Total Outflow = (-$637,000) + (-$352,986.57)

= -$989,986.57

b) INFLOW:

n= 5 years
r= 6.00%

After tax saving in interest,

PV of Cash cost saving less tax benefits= $14,000,000.x (11% - 9.8% ) x (1 - 35%) x PVIFA (12%, 10 years)
= $14,000,000.x 1.2% x 65% * 5.65022

= $617,004.35 is PV of Total outflow

c) Net present value

Net Present value = $617,004.35 - $989,986.57

= -$372,982.22 is the Net present value

d) No, since Net present value of the bond refinancing is less than zero which reflects deterioration of the shareholder's wealth.

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