The Bowman Corporation has a bond obligation of $26 million outstanding, which i

Question

The Bowman Corporation has a bond obligation of $26 million outstanding, which it is considering refunding. Though the bonds were initially issued at 11 percent, the interest rates on similar issues have declined to 9.9 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 7 percent on the old issue. The underwriting cost on the new $26,000,000 issue is $560,000, and the underwriting cost on the old issue was $450,000. The company is in a 35 percent tax bracket, and it will use an 10 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision, Calculate your final answer using the formula and financial calculator methods.

a. Calculate the present value of total outflows. b. Calculate the present value of total inflows.. c Calculate the net present value

Explanation / Answer

ANSWER A: PRESENT VALUE OF CASH OUTFLOWS:

1) Outflow on account of Call Premium

Call Premium = $ 26000000 * 7% = $ 1820000

After Tax Call Premium = $ 1820000 (1-0.35) = $ 1183000

We have considered after tax call premium because this expense will result in tax savings. Therefore, we have in-effect deducted tax savings from call premium outflow.

2) Underwriting cost on new issue $ 560000

Ammortisation cost per year=$ 560000/10 = $ 56000

Per Year Tax Savings on Ammortisation Cost = 56000 * 0.35 = $ 19600

Net Outflows = 560000 * 19600 * PVIFA(10%,10Years)= 560000 * 19600*6.145 = 560000 - 120442 = $ 439558

Present Value of Cash Outflows= Call Premium + Net Outflows of Ammortisation Cost

Call Premium is paid at T0 at the time of refunding old bonds, so its Present Value = Call Premium * 1 = Call Premium

Present Value of Cash Outflows= 1183000 + 439558 = $ 1622558

ANSWER B:- PRESENT VALUE OF CASH INFLOWS:-

1) Cost Savings on account of reduction of interest rates:-

11% on Old Bonds = 11% * 26000000 = $ 2860000

9.9% on New Bonds = 9.9% * 2600000 = $ 25740000

Annual Savings of Interest = $ 286000

Annual After tax savings = 286000 * ( 1-0.35) = $ 185900 ( because tax savings is income for the company thereby increasing tax payable)

Present Value of After tax Savings = Annual After tax savings * PVIFA(10%,10years) = 185900 * 6.145 =$1142355.50

2) Underwriting Cost Savings

Old Underwriting Cost = $ 450000

Amount Ammortised over 10 years = [450000/ 20] * 10 =22500*10 = $ 225000

Balance required to be written - off = $ 450000 - 225000 = $ 225000

Present Value of annual Future Write offs of old ammortisation amount = $ 22500*PVIFA(10%,10years)

Present Value of annual Future Write offs of old ammortisation amount = $ 22500* 6.145 = $ 138262.50

Immediate Gain on Writin off Balance of Underwriting = $ 225000 - 138262.50 = $ 86737.50

( This is because we will write off balance of old underwriting immediately, because we are refunding the old bonds.)

After tax gain on immediate write off of old ammortisation amount = 86737.50 * (1-0.35) = $56379.38

Present Value of Cash Inflows = Present Value of After tax Savings + After tax gain on immediate write off of old ammortisation amount

Present Value of Cash Inflows = 1142355.50 + 56379.38 = $ 1198734.88

ANSWER C: NET PRESENT VALUE

Net Present Value = PV of inflows - PV of Outflows

NPV = 1198734.88 - 1622558 = $(- 423823.12)

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