East Inc. has $450,000 (face value) callable bond outstanding. This bond pay 15%

Question

East Inc. has $450,000 (face value) callable bond outstanding. This bond pay 15% annual coupons, has maturity of 26 years and is callable at par value plus three annual coupons. Currently, East’s borrowing cost drops to 8%, so it is considering calling the bond and replacing it with a new issue that also pays 8% annual coupons. The flotation cost for the new issue is $13,500. East has to issue the new bond 30 days before calling the old bond and will temporary invest the proceeds in 30-day Treasury Bill that yields 3%. The tax rate is 30%. a. What is the NPV of calling the old bond? b. Suppose the call premium is X% of the total nominal (undiscounted) interest saved instead, what value of X that makes the NPV of calling the old bond zero?

Explanation / Answer

Soln : Company has to pay for this callable value = 450000 + 3*450000*0.15 = 652500

NPV = 652500/(1+0.03)^30/360 = $650894

NPV of calling the old bond = $650894

Total nominal undiscounted interest saved = (15-8)%*450000*26 = 31500*26 = $819000

So, the call premium = 650894/819000 = 79.47%

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