Thompson Enterprises has $5,000,000 of bonds outstanding. Each bond has a maturi

Question

Thompson Enterprises has $5,000,000 of bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%, and 15 years left to maturity. The bonds can be called at any time with a premium of $50 per bond.

If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations--assume that the firm's tax rate is zero.

The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?

Explanation / Answer

Price of this callable bond = $1000+50 = $1050

If the bonds are called, the company must pay flotation costs of $10 per new refunding bond.

--> Therefore if the bond price rises (interest rate falls) above $1050+$10 = $1060,
it would be profitable to call in the bonds and reissue them and sell at higher price

Find YTM (interest rate) that yield the bond price of $1040

1060 = (120/YTM)(1-1/(1+YTM)15) + 1000/(1+YTM)15

YTM can be solved using trial and errors

YTM = 11.43%

So, if the interest rate < 11.16% it will be profitable to call in the bonds

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