Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year b
ID: 2720410 • Letter: F
Question
Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon. NWW is now considering refunding these bonds. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of %11.67 in today's market. A call premium of 14% would be required to retire the old bonds, and flotations costs on the new issue would amount to $3 million. NWW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called (no overlapping interest.) Should the firm refund the bonds? Why?
Explanation / Answer
To decide whether to refund bonds, first we need to ascertain incremental cashflows if the bond is refunded.Then find NPV of the cashflows, if it is positive, refund bond
Step 1: Incremental initial flow (t0)
Step 2: Incremental inbetween cashflow (t1 - t25)
Step 3: Incremental terminal flow
Step 4: Calculation of NPV
In the absence of discount rate, coupon rate associated with new bond is the pre tax discounting rate.
post tax discounting rate = pre tax discounting rate * (1-tax rate)
= 11.67 * 60%
= 7.002%
Hence, discount the cashflows @7.002%
NPV = PV of inflows - PV of outflows
= 8,237,610.50 - 6,200,000
= $2,037,610.50
*PVAF = (1-(1+r)-n)/r = (1-1.07002-25)/.07002
**PVF = 1 / (1+r)n = 1 / 1.0700225
Decision: Since the NPV of cashflow is positive, refund bond
Raise the fund 50,000,000 Repay the old bond (50,000,000) Floatation cost on new bond (3,000,000) Call Premium (50,000,000*14%) (7,000,000) Tax saved on call premium (7,000,000*40%) 2,800,000 Tax saved on unamortised portion of floatation cost of old bond (WN 1) 1,000,000 (6,200,000)Related Questions
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