The Sunbelt Corporation has $45 million of bonds outstanding that were issued at

Question

The Sunbelt Corporation has $45 million of bonds outstanding that were issued at a coupon rate of 12.275 percent seven years ago. Interest rates have fallen to 11.50 percent. Mr. Heath, the Vice-President of Finance, does not expect rates to fall any further. The bonds have 18 years left to maturity, and Mr. Heath would like to refund the bonds with a new issue of equal amount also having 18 years to maturity. The Sunbelt Corporation has a tax rate of 36 percent. The underwriting cost on the old issue was 3.4 percent of the total bond value. The underwriting cost on the new issue will be 1.6 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a call premium of 8 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.

b. Calculate the present value of total outflows

c. Calculate the present value of total inflows

d. Calculate the net present value

Explanation / Answer

A) Compute the discount rate Discount rate = 11.50%*(1-tax rate) Discount rate = 11.50%*(1-36%) Discount rate = 7.36% B) Calculate the present value of total outflows Call premium = (8-1/2*1)% * 45,000,000 Call premium = $ 3375000 New Underwriter Commission = 1.6%*45000000 New Underwriter Commission = $ 720000 Present value of total outflows = 3375000+720000 Present value of total outflows = $ 4095000

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