Gainesville soap company issued $1,000,000, of 14 percent coupon, 30 year bonds-
ID: 2752072 • Letter: G
Question
Gainesville soap company issued $1,000,000, of 14 percent coupon, 30 year bonds- 10 years ago. Interest rates have fallen and Gainsville is thinking about replacing this bond with a new 20 year 12 percent coupon bond. The new bond could be sold at par. The old bonds have flotation costs of $60,000 which Gainsville was amortizing over a 30 year period. If the old bond is called in there will be a 10 percent call premium. Flotation costs on the new issue would be 2 percentor $20,000. The new bonds will be issued 2 months before the old bond is called. Proceeds from the new bond can be invested in commercial paper which earns 3 percent annually. Gainsville is in the 30 percent tax bracket and has a WACC of 18 percent.
Explanation / Answer
Call Premium Paid = 1000000*10% = 100000
Flotation cost on new Bond = 20000
Net Interest cost first 2 month = 1000000*12%*2/12 -1000000*3%*2/12
Net Interest cost first 2 month = 15000
Total Initial Cash outlay = -Call Premium Paid - Flotation cost on new Bond - Net Interest cost first 2 month
Total Initial Cash outlay = -100000 - 20000 - 15000
Total Initial Cash outlay = -135000
Annual Post tax interest cash saving = (14%-12%)*1000000 *(1-30%)
Annual Post tax interest cash saving = 14000
Annual Old Flotation amortisation expenses = 60000/30 = 2000
Annual new Flotation amortisation expenses = 20000/20 = 1000
Tax saving on old unamortised flotation cost , call premium & additional interest cost = (60000 - 2000*10) *30% + 100000*30% + 15000*30%
Tax saving on old unamortised flotation cost , call premium & additional interest cost= 46500
Tax loss on decrease annual Flotation amortisation expenses = (2000-1000)*30% = 300
NPV of Refunding = -Total Initial Cash outlay + Tax saving on old unamortised flotation cost , call premium & additional interest cost /(1+r) + (Annual Post tax interest cash saving - Tax loss on decrease annual Flotation amortisation expenses)*(1-(1+r)^-n)/r
NPV of Refunding = - 135000 + 46500/1.18 + (14000-300)*(1-(1+18%)^-20)/18%
NPV of Refunding = - 22,260.59
b)
Gainsville should not refund as its NPV is negative
Tax saving on old unamortised flotation cost =
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