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Chapter 5: Q18BP-c (page 530)

The Robinson Corporation has $43 million of bonds outstanding that were issued at a coupon rate of 11戮 percent seven years ago. Interest rates have fallen to 10戮 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 an 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 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.) Assume the discount rate is equal to the after-tax cost of new debt rounded up to the nearest whole number.

c. Calculate the present value of total inflows.

Short Answer

Expert verified

The present value of total inflows is $2,847,348.

Step by step solution

01

Information available

Bond obligation = 43,000,000

Interest rate at the time of issue = 11戮%

Interest rate after decline = 10戮%

Time remaining of bonds = 17 years

Call premium on old issue =9%

Underwriting cost of new issue =1.7% of total bond value

Underwriting cost on old issue = 2.4% of total bond value

Tax rate = 30%

Discount rate = 8%

02

Calculation of the present value of interest savings

The present value of interest savings is $2,745,722.

Interest savings=Interest on old bonds-Interest on new bonds1-Tax rate=$43,000,000脳11.75%-$43,000,000脳10.75%脳1-30%=$5,052,500-$4,622,500脳(1-30%)=$430,000脳(1-30%)=$301,000

Present value of interest savings=Interest savings脳PVAFi=8%,n=17years=$301,000脳9.122=$2,745,722

03

Calculation of present value of gain on underwriting cost

The present value of gain on the underwriting cost is $101,626.

Unamortized underwriting cost=Original amount-Amount written off=2.4%脳$43,000,000-$43,000,000脳2.4%24脳7=$1,032,000-$301,000=$731,000

PV of deferred future underwriting cost=Future underwriting costTime remaining脳PVAFi=8%,n=17years=$731,00017脳9.122=$43,000脳9.122=$392,246

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Most popular questions from this chapter

A \(1,000 par value bond was issued 25 years ago at a 12 percent coupon rate. It currently has 15 years remaining to maturity. Interest rates on similar obligations are now 8 percent.

a. What is the current price of the bond? (Look up the answer in Table 16-2.)

b. Assume Ms. Bright bought the bond three years ago when it had a price of \)1,050. What is her dollar profit based on the bond鈥檚 current price?

c. Further assume Ms. Bright paid 30 percent of the purchase price in cash and borrowed the rest (known as buying on margin). She used the interest payments from the bond to cover the interest costs on the loan. How much of the purchase price of $1,050 did Ms. Bright pay in cash?

d. What is Ms. Bright鈥檚 percentage return on her cash investment? Divide the answer to part b by the answer to part c.

e. Explain why her return is so high.

Howell Auto Parts is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If the company purchases the asset, the cost will be \(10,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent.

The other alternative is to sign two operating leases, one with payments of \)2,600 for the first two years, and the other with payments of $4,600 for the last two years. In your analysis, round all values to the nearest dollar.

c. Compute the amortization schedule for the loan. (Disregard a small difference from a zero balance at the end of the loan鈥攄ue to rounding.)

Question: The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at \(24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for \)10.75 million, the fiber technology division for \(8.45 million, and the synthetic products division for \)20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share.

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What was the primary purpose of the Securities Act of 1933?

Question: The Bowman Corporation has a \(18 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 10 percent, the interest rates on similar issues have declined to 8.5 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new \)18,000,000 issue is \(530,000, and the underwriting cost on the old issue was \)380,000. The company is in a 35 percent tax bracket, and it will use an 8 percent discount rate (rounded after-tax cost of debt) to analyze the refunding decision.

a. Calculate the present value of total outflows.
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