The Sunbelt Corporation has $30 million of bonds outstanding that were issued at

Question

The Sunbelt Corporation has $30 million of bonds outstanding that were issued at a coupon rate of 10.775 percent seven years ago. Interest rates have fallen to 10.20 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 2.3 percent of the total bond value. The underwriting cost on the new issue will be 1.1 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).

Compute the discount rate. (Do not round intermediate calculations. Input your answer as a percent rounded up to the nearest whole percent.)

Calculate the present value of total outflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)

Calculate the present value of total inflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)

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.)

Should the Sunbelt Corporation refund the old issue?

The Sunbelt Corporation has $30 million of bonds outstanding that were issued at a coupon rate of 10.775 percent seven years ago. Interest rates have fallen to 10.20 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 2.3 percent of the total bond value. The underwriting cost on the new issue will be 1.1 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)

discount rate = 10.2%*(1-36%) = 6.53% = 7%

b)

PV of inflows

Interest savings per year = 30000000*(10.775%-10.2%) = 172500

after tax savings = 172500*(1-36%) = 110400

PV at 8% for 18 years = 110400*10.06 = 1110523.19 (10.06 is PV factor )

underwriting cost = 2.3%*30000000 = 690000

Amount written off over last 7 years at  27600 per year (690000/25) x 7 = 193200

Unamortized old underwriting cost = 690000 - 193200 = 496800

Pv of remaining 18 payments = 27600*10.06 = 277630.80

Immediate gain in old underwriting write-off = 496800 - 277630.80 = 219169.20

After tax = (1-36%)*219169.20 = 140268.29

Total inflow = 1110523.19 + 140268.29 = 1250791.48

c)

Payment on call provision = 6.5%*30000000*(1-36%) = 1248000

Underwriting cost on new issue

Actual expenditure = 1.1% * 30000000 = 330000

PV of tax savings = 10.06*36%*(330000/18) = 66389.97

Total outflow = 1248000 + 66389.97 = 1314389.97

4)

NPV = PV of inflows - PV of outflows = 1250791.48 - 1314389.97 = -63598.49

5)

No, As NPV is negative

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