The Robinson Corporation has 55 million of bonds outstanding that were issued at

Question

The Robinson Corporation has 55 million of bonds outstanding that were issued at a coupon rate of 10 and a half percent seven years ago. Interest rate have fallen to nine and a half percent. Mr. Brooks, the vice president of finance, does not expect rates to fall any further. The bonds have 14 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 14 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 2.1 percent of the total bond value. The underwriting cost on the new issue will be 1.4 percent of the total bond value. The orginial bond indenture contained a five year protection against a call, with a 7.5 percent call premium starting in the sixth year and scheduled to decline by one half percent each year thereafter. (Consider the bond to be 7 years old for purposes of computing the premium). Assume the discount rate is equal to the aftertax cost of new debt rounded to the nearest whole number.

What would be the aftertax cost of the call premium at the end of year 11 (in dollar value)?

Explanation / Answer

call premium after 11 years = 5%

=> 55000000 * 5% = 2750000

aftertax cost of call premium = 2750000 * (1-0.3) = 1925000

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