Question

The Breaker Brothers Finance Company is reviewing some debentures that carry fairly high annual payments. As the New V.P. Finance, you are asked whether the bond issue that was issued 5 years ago with 18 years to maturity at annual rate of 10 percent, it has a call provision at a premium of 6 percent above par value. The bond issued has $43 million outstanding

Current long-term interest rates are 7 percent and short-term rates are 4 percent. If the old bonds are called, a 30 day overlap period will be required. The Breaker Brothers Finance Company has a tax rate of 45 percent. Underwriting and other expenses will be $750,000.

Should the old issue be refunded and replaced with a debt issue with a comparable maturity?

Show your calculations

Answer 1

Calculation of Initial Investment:

Redemption of old debentures $43+6%= $45.58

Post Tax interest on old debentures for overlaping period $43*10%*(1/12)*.55 = $0.20

Less:Proceeds from new debentures $43

Less:Tax shield on call premium $2.58(i.e.43*6%)*.55=$1.42

Initial investment =$1.36million

Calculation of Savings

old new

Annual Post Tax Interest 2.37($43*10%*.55) $1.66($43*7%*.55)

Less:tax sheild on amortisation of underwriting ex. $0.03 ($.75*(1/13)*.45)

Post tax cash outflow $2.37 $1.63

Post tax annual savings $.74 per annum for 13 years

NPV of the project .74PVAF(7%,13)-1.36=.74*8.36-1.36=$4.83million

Since, NPV positive replacement should be done.