Question

The Robinson Corporation has $27 million of bonds outstanding that were issued at a coupon rate of 10.950 percent seven years ago. Interest rates have fallen to 10.250 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 2.70 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 6 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.) Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole percent (e.g. 4.06 percent should be rounded up to 5 percent) a. Compute the discount rate. (Do not round intermediate calculations. Input your answer as a percent rounded up to the nearest whole percent.) 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.)

Answer 1

a) After-tax cost of debt = Current YTM x (1 - tax) = 10.250% x (1 - 30%) = 7.175% = 8%

b) The firm need to pay the call premium in addition to the underwriting cost in order to issue new bonds.

PV of outflows = 27,000,000 x (1 + 5.5%) x (1 + 1.80%) = $28,997,730

c) Annual coupon savings = 27,000,000 x (10.95% - 10.25%) = $189,000

PV of savings can be calculated using PV function

N = 17, PMT = 189,000, FV = 0, I/Y = 7.175% => Compute PV = $1,823,090.92

Also the firm will get $27m from the new issue.

PV of total inflows = $28,823,090.92

d) NPV = PV inflows - PV outflows

= 28,823,090.92 - 28,997,730 = - $ 174,639.08