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). 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

Answer for question no.a:

Discount rate is nothing but the current interest rate at which the new bonds are issued minus the tax benefit. ie., 11.50% *(1-0.36)=7.36% rounded to 8%.

Answer for question no.b:

Total cash outflows:

Amount to be paid to the existing bond holders=$45,000,000.

Underrwriting cost of the new issue=1.6% of $45,000,000

=$720,000.

To be amortized over a period of 18 years =$720,000/18

=$40,000.

Bond period =18 years.

Tax savings per year for 18 years on underwriting comission amortized=$40,000 * 36%

=$14,400

Present value of tax savings for 18 years @ discount rate of 8% =$14,400 *(1-(1+i)-n)/i

i is the interest rate and n is the number of years.

=$14,400 *(1-(1+.08)-18)/.08

=$14,400 *9.818

=$141,381.32 rounded to $141,381.32..

Underwriting cost to be written off every year =$1,530,000/25 =$61,200.

Cash outflow on account of underwriting comission net of tax savings on future payments=$720,000-$141,381.32

=$578,618.68-------(A)

Call premium:

Call premium in the 6th year =8%.

Decrease in call premium by 0.5% per year thereafter,

The bonds are being called back in the 8th year therefore, the effective call premium =8% - 0.5% =7.5% (it is mentioned that for calculation of call premium only 7 years have been elapsed since the issue of the bond)

Call premium to be paid =$45,000,000 * 7.5%

=$3,375,000

Outflow on call premium after tax savings =$3,375,000 *(1-0.36)

=$2,160,000------------(B)

Present value of total outflows:

Call premium net off tax savings + under writing comission paid net of tax savings.

=B+A

=$2,160,000+$578,618.68

=$2,738,618.68-----------(E)

Interest savings:

After tax cost of interest on initial issue of bonds =$45,000,000 * 12.275%=$5,523,750(1-0.36)

=$3,535,200.

After tax cost of interest on fresh issue of bonds =$45,000,000 *11.50%*(1-0.36) =$3,312,000

Savings in after tax interest per year =$3,535,200 -$3,312,000

=$223,200.

Present value of savings in interest for 18 years =$223,200 *(1-(1+.08)-18)/.08

=$223,200 * 9.37188

=2,091,805.21--------(C).

Underwriting cost gain:

Underwriting comission on old issue=$45,000,000*3.4%

=$1,530,000.

Amortization per year=$1,530,000./25=$61,200.

Already amortized till date = $61,200*7

=$428,400.

Amount still remaining umamortized =$1,530,000 -$428,400.

=$1,101,600.

In case the underwriting comission is written off over a period of 18 years then present value of future payments would be $61,200 *(1-(1+.08)-18)/.08

=$61,200 * 9.37188

=$573,559.49.

Because the underwriting comission is written off immediately, it has resulted in immediate payment in excess of future payments to the extent of $1,101,600. - $573,559.49.

=$528,040..51.

Tax savings on this would be $528,040.51 *36%

=$190094.58-------(D)

Present value of cash inflows =C+D

=$2,281,899.79.------------(F)

NPV

NPV = Present value of cash inflows - Present value of cash outflows

=(F) - (E)

= -$456,718.88

As the NPV is negative, the old bonds should not be repaid with the new bonds.

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