Question

3. The Sunbelt Corporation has $31 million of bonds outstanding that were issued at a coupon rate of 10.875 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 2.4 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 7 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 after-tax 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? (Yes/No)

Answer 1

a) Discount rate = 10.20%* (1-0.36) = 0.06528 or 6.53% or 7%

b) Amount paid to retire old bonds by paying premium of 6.5% = $31 million *1.065 = $33.015 million

Proceeds from new bond issue =$31 million*(1-0.011)=$30.659 million

Outflows will be amount paid to retire old bonds and new bond coupons and face value redemption

Annual coupon payments = $31 million *10.2% = $3.162 million

So, PV of cash outflows($ million) = 33.015 + 3.162/0.06528*(1-1/1.06528^18) + 31/1.06528^18

= $75.866 million or $75,866,045.09

c) Inflows will be proceeds from new bond issue and coupon payments and face value redemption of old issue (which was not paid)

Old coupon amount = $31 million *10.875% = $3.37125 million

PV of Inflows($ million) = 30.659 + 3.37125/0.06528*(1-1/1.06528^18)+31/1.06528^18 = $75.68854602 million

or $75,688,546.02

d) NPV = PV of Inflows - PV of outflows

= $75,688,546.02 - $75,866,045.09

= - $177499.07

e) As the NPV is negative , the old issue should not be refunded