The Robert Corp has $26 million of bonds outstanding that were issued at a coupo

Question

The Robert Corp has $26 million of bonds outstanding that were issued at a coupon rate of 10.850 percent seven years ago. Interest rates have fallen to 10.150 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 2.60 percent of the total bond value. The underwriting cost on the new issue will be 1.80 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a call premium of 7 percent 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.) Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole percent.

a. Compute the discount rate Do not round intermediate calculations and round your answer to 2 decimal places.)

b. Calculate the present value of total outflows Do not round intermediate calculations and round your answer to 2 decimal places.)

c. Calculate the present value of total inflows. Do not round intermediate calculations and round your answer to 2 decimal places.)

d. Calculate the net present value. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)
  

Explanation / Answer

a. Computation of discount rate:

Step 1: Calculation of cash required for redemption of old bonds:

Step 2: Calculation of face value of new bonds to be issued:

New face value of bonds to be issued= Cash required for redemption / (1-Underwriting commission rate)

= 27560000/(1-1.8%) = 28065173

Reconciliation:

Interest payable every year= 28065173 *10.15%= 2848615

After tax cost of interest= Interest *(1-Tax rate)= 2848615*70%= 1994030

After tax discount rate= After tax interest cost/ Face value of bonds issued= 1994030/28,065,173= 7%

b. Calculation of present value of total outflows:

Issue of new bonds creating additional interest outflow after tax as outlined below:

So for 17 years every year there is an additoinal outflow of 19330.54 in interest and,

as the redemption value of new issue is higher than the redemption value of old issue if redeemed after 17 years af shown below:

Present value calculation:

Annuity present value factor used for interest discounting and present value factor used for terminal outflow discounting.

c. Present value of total inflows:

As cash proceeds from new debt issue totally used for redemption, there is no net cash inflow, cash inflow= 0

d. NPV= present value of inflows- present value of outflows = 0 -842509.42 = -842509.42

Face value of bonds          26,000,000 Add: Premium Premium rate 7% Less: Decline for 2 years 0.5% *2 1% Net premium rate 6% Amount of premium 26M*6%            1,560,000 Total value of redemption          27,560,000

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