The Sunbelt Corporation has $34 million of bonds outstanding that were issued at
ID: 2744759 • Letter: T
Question
The Sunbelt Corporation has $34 million of bonds outstanding that were issued at a coupon rate of 11.175 percent seven years ago. Interest rates have fallen to 10.50 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 2.1 percent of the total bond value. The underwriting cost on the new issue will be 1.2 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a call premium of 7 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). 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.)
Discount rate
%
b.
Calculate the present value of total outflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)
PV of total outflows
$
c.
Calculate the present value of total inflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)
PV of total inflows
$
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.)
Net present value
$
The Sunbelt Corporation has $34 million of bonds outstanding that were issued at a coupon rate of 11.175 percent seven years ago. Interest rates have fallen to 10.50 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 2.1 percent of the total bond value. The underwriting cost on the new issue will be 1.2 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a call premium of 7 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). 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).
Explanation / Answer
a. Computation of discount rate:
Fallen Interest rate (1 - tax rate) = 10.50%(1-36%) = 10.50% * 0.64 = 6.72% = 7% rounded off.
b. Calculation of the present value of total outflows:
From the above calculation table
b. Outflows are 1 and 2 i.e, PV of outflows = 1 + 2 = 1,745,924.48
1. Payment on call provision = 1,414,400
2.Underwriting cost on new issue = 331,524.48
c. Inflows are 3 and 4 , PV of inflows = 3 + 4 = 1,534,265.4
3. Cost savings in lower interest rates = 1,376,59.36
4.Underwriting cost on old issue = 157,706.04
d. Net present value = 1,745,924.48 - 1,534,265.4 = -211,659.08
Based on the negative net present value, the Sunbelt Corporation should not refund the issue.
1. Payment on call provision $34,000,000 × 6.5% $2,210,000 2,210,000 ( 1 - tax rate) = 2,210,000 * 0.64 1,414,400 2. Underwriting cost on new issue: Actual expenditure( 1.2% * $34,000,000) 408,000 Amortization of costs ($408,000/18) = 22,666.666Tax savings per year = 22,666.666 * (.36) 8,160 PV of future tax savings 8,160 * {PVfor n = 18, i = 8% } = 8,160 * 9.372 76,475.52 Net cost of underwriting expense on new issue = Actual expenditure - PV of future tax savings = 408,000 - 76,475.52 331,524.48 3. Cost savings in lower interest rates: (interest on old bond) × $34,000,000 = 11.175 % * 34,000,000 3,799,500 (interest on new bond) × $34,000,000 = 10.50 % * 34,000,000 3,570,000 Savings per year 229,500 Savings per year after tax = 229,500( 1 -0.36) 146,880 Present value of savings = 146,880 * {PVfor n = 18, i = 8% } = 146,80 * 9.372 1,376,559.36 4. Underwriting cost on old issue: Original amount (2.1% × $34,000,000) 714,000 Amount written off over last 7 years at $28,560 per year ($714,000/25) × 7 199,920 Unamortized old underwriting cost = original amount - Amount written off = 714,000 - 199,920 514,080 Present value of deferred future write off:$28,560 × 9.372
(n = 18, i = 8%) 267,664.32 Immediate gain in old underwriting write-off = 514,080 - 267,664.32 246,415.68 Less: Tax 36% 88,709.64 After tax value of immediate gain in old underwriting cost write-off 157,706.04
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