The Sunbelt Corporation has $37 million of bonds outstanding that were issued at
ID: 2799879 • Letter: T
Question
The Sunbelt Corporation has $37 million of bonds outstanding that were issued at a coupon rate of 11.475 percent seven years ago. Interest rates have fallen to 10.75 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 2.4 percent of the total bond value. The underwriting cost on the new issue will be 1.3 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). 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. (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
$
e.
Should the Sunbelt Corporation refund the old issue?
The Sunbelt Corporation has $37 million of bonds outstanding that were issued at a coupon rate of 11.475 percent seven years ago. Interest rates have fallen to 10.75 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 2.4 percent of the total bond value. The underwriting cost on the new issue will be 1.3 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). 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).
Explanation / Answer
a. Computation of discount rate:
Given that discount rate is equal to the after tax cost of new debt.
That implies = cost of new debt * (1-tax rate)
= 10.75 * (1-36%)
= 10.75 * 0.64 = 6.88% = 7% rounded
b. Computation of Present value of Total outflows:
Here we have two cash outflows:
first, Payment on call premium:
=$37million * (7%-0.5%)* (1-36%)
= $37million* 6.5% * 0.64
=$1,539,200
Second, underwriting cost on new issue:
Cost of underwriting = Actual expenditure - Present value of tax savings on expenditure
Here, Actual expenditure = $37million * 1.3%= 481,000
Now, let us find the Present value of tax savings on expenditure:
Tax savings on Amortization of cost = Amortization of cost * tax rate
= (481,000 / 18years left)*36%
= 26,722.22*0.36 = 9,620
Present value of tax savings = PVIFA(7%, 18years) * Tax savings on Amortization of cost
= 10.059* 9,620 = $96,767.58
Cost of underwriting = Actual expenditure - Present value of tax savings on expenditure
= 481,000 - 96,767.58 = $384,232.42
Therefore, Total outflows = Call premium + cost of underwriting
=$1,539,200 + 384,232.42 = $1,923,432.42
C. Computation of Present value of Total inflows:
Here we have two cash outflows:
first, savings in low interest rates:
Interest on old bond - interest on new bond =$37million * (11.475% - 10.75%)
= 268,250
After tax savings = 268,250*(1-36%) = 171,680
Present value of after tax savings in interest = PVIFA(7%, 18years) * after Tax savings
= 10.059* 171,680 = $1,726,929.12
Second, underwriting cost on old issue:
immediate gain from old under writing write-off = Unamortized old under writing cost - Present value of annual amortization cost
= ($37million * 2.4%) - Amortization cost for 7 years - Present value of annual amortization cost
= 888,000- (888,000 / 18+7)*7 years - (888,000/ 18+7 years)* 10.059
= 888,000 - 248,640 - 35,520*10.059
= 282,064.32
After tax immediate gain = 282,064.32*36% = 101,543.16
Total present value of cash inflows = $1,726,929.12 + 101,543.16 = $1,828,472.28
d. Net present value = PV of outflows - PV of inflows
= $1,923,432.42 - $1,828,472.28
= $94,960.14
e. here, the NPV is positive, Sunbelt Corporation can refund the old issue.
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