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XYZ Company is in awe at the recent change in interest rates. The current intere

ID: 2665080 • Letter: X

Question

XYZ Company is in awe at the recent change in interest rates. The current interest rate on A2 rated bonds is currently at 6 percent. The $30 million, 15-year bond issue that the company has outstanding was initially issued at 9 percent five years ago.

XYZ is considering refunding the bond issue due to this decline. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life.

A. Compute the price of the old bonds in the open market using annual analysis. Determine the price for a single $1,000 par value bond.

B. Compare the price in part A to the 8 percent call premium over par value. Which appears to be more attractive in terms of reacquiring the old bonds?

Explanation / Answer

a. Price of Old Bond

Present Value of Interest Payments
PVA = A x PVIFA (n = 10, i = 8%)
PVA = $100 x 6.710 = $738.10

Present Value of Principal Payment at Maturity
PV = FV x PV (n = 10, i = 8%)
PV = $1,000 x .463 = $463

Total Present Value
Present Value of Interest Payments         $738.10
Present Value of Principal Payment          $463.00
Total Present Value or Price of Bond        $1201.10

b.The price of $1,201.10 is more than 20 percent over par. The Call price is only 10 percent over par. Clearly, calling in the bonds is more attractive than repurchasing them in the open market.