The Robinson Corporation has 43 million of bonds outstanding

The Robinson Corporation has $43 million of bonds outstanding that were issued at a coupon rate of 11.750 percent seven years ago. Interest rates have fallen to 10.750 percent. Mr. Brooks, the Vice-President of Finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 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 1.7 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a 9 percent call premium 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

B. Calculate the present value of total outflows

C. Calculate the present value of total inflows

D. Calculate the net present value

Solution

1. Discount Rate:

= After tax cost of New Debt

= 10.750 (1 - .30) = 7.525 = 8%

2. Present Value of Cash Outflows

a) Payment of Call provision

Call Premium = 8.5% for 7^th year

Total Amount = 43,000,000 * 8.5% = 3,655,000

After tax cost = 3,655,000 (1- .30) = 2,558,500

b) Underwriting Cost on New Issue:

Actual underwriting cost = 43,000,000 * 1.7 % = 731,000

Annual Amortization = 731,000 / 17 = 43,000

Annual tax savings on amortization (43,000 * 0.30) = 12,900

PV of future tax savings (12,000 * PVAF, n= 17, I= 8%) = 12,000 * 9.122 = 117,674

Net Cost of Underwriting Expense = Total Cost – Tax Savings

= 731,000 – 117,674 = 613,326

Present Value of Cash Outflows = 2,558,500 + 613,326 = 3,171,826

3. Present Value of Cash Inflow

a) Cost of Savings in lower interest rate

43,000,000 (11.750 – 10.750) = 430,000 per year

After tax savings (430,000 * (1 – 0.30)) =301,000

Present Value = 301,000 * PVAF, n=17, i=8% = 301,000 * 9.122 = 2,745,722

b) Savings in Underwriting Cost Amortization

Total underwriting cost on old issue (43,000,000 * 2.4%) = 1,032,000

Amount written off over last 7 years (1,032,000/24) * 7 = 301,000

Unamortized amount outstanding (1,032,000 – 301,000) = 731,000

Annual amortization for next 17 years (731,000/17) = 43,000

Present Value (43,000 * PVAF, n=17, i= 8%) = 43,000 * 9.122 = 392,246

Excess of new underwriting cost over old (731,000 – 392,246) = 338,754

Value of savings in the form of tax shield = 338,754 * 0.30) = 101,626

Present Value of total inflows = 2,745,722 + 101,626 = 2,847,348

4. Net Present Value

PV of Inflows – PV of Outflows = 2,847,348 – 3,171,826 = (324,478)