High-Gearing Incorporated is considering offering a new $40 million bond issue to replace an outstanding $40 million bond issue. The firm wishes to take advantage of the decline in interest rates that has occurred since the original issue. The two bond issues are described in what follows. The firm is in the 40% tax bracket.
Old bonds. The outstanding bonds have a $1,000 par value and a 10% coupon interest rate. They were issued five years ago with a 25-year maturity. They were initially sold at a $25 per bond discount, and a $200,000 floatation cost was incurred. They are callable at $1,100.
New bonds. The new bonds would have a 20-year maturity, a par value of $1,000, and a 7.5% coupon interest rate. It is expected that these bonds can be sold at par for a floatation cost of $250,000. The firm expects a three-month period of overlapping interest while it retires the old bonds.
1. Calculate the initial investment that is required to call the old bonds and issue the new bonds.
2. Calculate the annual cash flow savings, if any, expected from the proposed bond-refunding decision.
3. If the firm uses its 4.5% after-tax cost of debt to evaluate low-risk decisions, find the net present value (NPV) of the bond-refunding decision. Would you recommend the proposed refunding? Explain your answer.