Leyland Enterprises has $5,000,000 in bonds outstanding. The bonds each have a m

Question

Leyland Enterprises has $5,000,000 in bonds outstanding. The bonds each have a maturity value of $1,000, an annual coupon of 12 percent, and 15 years left until maturity. The bonds can be called at any time at a call price of $1,100 per bond. If the bonds are called, the company must pay flotation costs of $50,000 ($10 for every $1,000 of bonds outstanding.) Igonore tax considerations. Assume that the tax rate is zero. The company's decision whether to call the bonds depends critically on the current interest rate it would pay on new bonds issued. What is the breakeven interest rate, which is profitable to call in the bonds?

Explanation / Answer

Cashflow at t0 if the bonds are called:
Callable bonds at $1100 * 5000 bonds = $5,500,000
Flotation Costs = $50,000
Total Cashflow = $5,550,000

Cashflows if the bonds are not called:
t1 to t15: Annual coupon @ 12% = $5,000,000 * 12% = $600,000
t15: Repayment of bond = $5,000,000

We need to find the breakeven interest rate which is nothing but the IRR. Using excel or a financial calculator, IRR = 10.51%. The breakeven interest rate which is profitable to call in the bonds is 10.51%

Year Cashflows 0 -5550000 1 600000 2 600000 3 600000 4 600000 5 600000 6 600000 7 600000 8 600000 9 600000 10 600000 11 600000 12 600000 13 600000 14 600000 15 5600000

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