The Robinson Corporation has $43 million of bonds outstanding that were issued a

Question

The Robinson Corporation has $43 million of bonds outstanding that were issued at a coupon rate of 11.750 percent seven years ago. Interest rates have fallen to 10.750 percent. Mr. Brooks, the Vice-President of Finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 2.4 percent of the total bond value. The underwriting cost on the new issue will be 1.7 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a 9 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter. (Consider the bond to be seven years old for purposes of computing the premium.) Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole percent (e.g. 4.06 percent should be rounded up to 5 percent).

Explanation / Answer

1.)Calculation of initial cash outlay :

a.Face value of old bonds -$43million

Add:Call premium -$3.44million(9%in 6th year,8.5%in 7th year,8%in 8th year)

Cost of calling old bonds -$46.44million

b.Gross proceeds of new issue -$43 million

less:issue costs@1.7% -$0.731million

   Net proceeds from new issue -$42.269 million

c.Tax savings on call premium paid and unamortized underwriting cost on old bonds

-0.30(1.032+3.44)

-$1.3416

Total initial cash outlay =46.44 - (42.269+1.3416)

=$2.8294 million

2.Calculation of net present value of refunding of bond :

Savings in annual interest expenses (43(11.75-10.75)) -$ 0.43 million

Less: Tax saving on interest and amortization differences -$ 0.1343 million (0.30(0.43+(1.032-0.731)/17)

Annaul net cash savings $0.2957 million

Present value factor for (8%,17years) 9.121638 (Note .1)

Present value of net annual cash savings = $2.6973 million

Less: Initial outlay = $2.8294 million

   Net present value of refunding bond =($0.1321million)

Advice: Do not refund the bond since it is showing negative npv.

note 1: since new interest rate after tax to be treated as present value factor 7.525% shall be taken however it was given clear that it can be rounded off to 8%.

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