Question

The Bowman Corporation has a bond obligation of $23 million outstanding, which it is considering refunding. Though the bonds were initially issued at 12 percent, the interest rates on similar issues have declined to 10.7 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 8 percent on the old issue. The underwriting cost on the new $23,000,000 issue is $530,000, and the underwriting cost on the old issue was $420,000. The company is in a 35 percent tax bracket, and it will use an 12 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 inflows $

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 $

Answer 1

a. Payment of call premium = $23,000,000*8%

= $1,840,000

After tax outflow = 1,840,000*(1-35%)

= $1,196,000

Underwriting cost on new issue: Amortization of costs (530,000/10)*0.35 = $18,550 tax savings each year

Actual expenses = 530,000. PV of future tax savings = 18550*PVIFA for n = 10 and i = 12

= 18550*5.650

= 104,807.50

Thus present value of outflows = $1,196,000+104,807.50

= $1,300,807.50

b. Cost savings in lower interest rates = 12% * 23,000,000 = 2,760,000 (old bond)

10.7%*23,000,000 = 2,461,000 (new bond)

Savings = 2760000-2461000 = $299,000

After tax savings = 299,000*(1-35%) = $194350

194350*PVIFA for n = 10 and i = 12

= 194350*5.65

= $1,098,077.50

c. Net present value = PV of inflows - Pv of outflows

= $1,098,077.50 - $1,300,807.50

= - $202,730