The State of Idaho issued $2,000,000 of seven percent coupon, 20-year semiannual

Question

The State of Idaho issued $2,000,000 of seven percent coupon, 20-year semiannual payment, tax-exempt bonds five years ago. The bonds had five years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be five percent of the face amount. Today 15-year, five percent, semiannual payment bonds can be sold at par, but flotation costs on this issue would be two percent. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.

Explanation / Answer

Cost of refunding:

Call Premium = 5% (2mil) = 100,000 ;

Floatation cost = 2% (2mil) = 40,000 ;

Total investment outlay = 140,000 ;

Interest on old bond = 7%/2(2mil) = 70,000 ;

Interest on new bond = 5%/2(2mil) = 50,000;

Savings = 20,000 ;

PV of savings, 30 periods at 5%/2 = 418,606

NPV of refunding = PV of savings - cost of refunding = 278,606

ans is $278606

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