Chapter 16: The Bowman Corporation has a bond obligation of $10 million outstand

Question

Chapter 16: The Bowman Corporation has a bond obligation of $10 million outstanding, which it is considering refunding. Though the bonds were initially issued at 11 percent, the interest rates on similar issues have declined to 10.0 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a call premium of 7 percent on the old issue. The underwriting cost on the new $10,000,000 issue is $400,000, and the underwriting cost on the old issue was $290,000. The company is in a 35 percent tax bracket, and it will use an 9 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision. Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

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

PV of total outflows _____

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

c. 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.)

Net Present Value_____

Explanation / Answer

a)

call premium = 7%*10000000 = 700000

After tax value = (1-35%)* 700000 = 455000

Underwriting costs = (400000 / 10) * 35% = 14000

PV of tax savings for next 10 years at 9%

PV = 14000*(1-(1+9%)-10)/9% = 89847.21

NPV = 400000 - 89847.21 = 310152.79

Total outflows = 455000 + 310152.79 = 765152.79

b)

Inflows

Interest on old bonds = 11%*10000000 = 1100000

Interest on new bonds = 10%*10000000 = 1000000

Savings = 1100000 - 1000000 = 100000

After tax savings = (1-35%)*100000 = 65000

PV of savings at 9% for 10 years = 65000*(1-(1+9%)-10)/9% = 417147.75

Underwriting cost on old issue

Original amount = 290000

Amortization per year = 290000/20 = 14500

Amount written over 10 years = 10*(14500) = 145000

Remaining unamortized amount = 290000 - 145000 = 145000

PV of remaining 10 payments = 14500*(1-(1+9%)-10)/9% = 93056.04

Gain = 145000-93056.04 = 51943.96

After tax gain = (1-35%)*(51943.96) = 33763.58

Total Inflows = 417147.75 + 33763.58 = 450911.33

c)

NPV = Inflows - outflows = 450911.33 - 765152.79 = -314241.47

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