Question

You are considering calling in existing bonds and issue a new set of bonds because the market interest rates have dropped significantly since you issued the current bonds. The current bonds pay an annual coupon of 12%. The market interest rate for long term securities has dropped to 8%. There are $20M in bonds outstanding and they have 10 years left to maturity. If we were to issue new bonds, we’d incur underwriting costs of $250,000. Per the bond indenture, the call premium on the bonds is 15%. There will also be an overlap period of 2 months if new bonds are issued. The short term interest rate is 2.5%. The company’s tax rate is 30%. Determine whether the bonds should be refunded.

Answer 1

1. Initial outlay	Mlns.	Mlns.
After-tax call premium on old bonds(20*15%*(1-30%))	-2.1
2-mths extra after-tax int. on old issue(20*12%/12*2*(1-30%))	-0.28
2 months after-tax int. on new issue(20*2.5%/12*2*(1-30%)	0.058333
Total after-tax initial investment		-2.32167
2.Annual underwriting costs amortisation tax effects
PV of annual underwriting costs tax effects(0.25/10*30%*6.71008)    (P/A,i=8%,n=10)		0.050326
3. Annual interest savings
PV of After-tax interest cost savings(20*(12%-8%)*(1-30%)*6.71008=		3.757645
P/A ,i=8.0%, n=10 yrs.
NPV of refunding (1+2+3)		1.486304
	ie.	1486304
		millions
As the NPV of refunding is POSITIVE, refunding of old bonds is recommended