Question

Web Tools Company is considering using the proceeds from a new $50 million bond issue to call and retire its outstanding $50 million bond issue. The details of both bond issues are outlined in what follows. The firm is in the 40% tax bracket.
Old bonds. The firm’s old issue has a coupon interest rate of 10%, was issued four years ago, and had a 20-year maturity. The bonds sold at a $10 discount from their $1,000 par value, floatation costs were $420,000, and their call price is $1,100.
New bonds. The new bonds are expected to sell at par ($1,000), have a 16-year maturity, and have floatation costs of $520,000. The firm will have a two-month period of overlapping interest while it retires the old bonds.
a. What is the initial investment that is required to call the old bonds and issue the new bonds?
b. What are the annual cash flow savings, if any, from the proposed bond-refunding decision if the new bonds have an 8% coupon interest rate? If the new bonds have a 9% coupon interest rate?
c. Construct a table showing the net present value (NPV) of refunding under the two circumstances given in part (b) when (1) the firm’s after-tax cost of debt is 4.8% [0.08 × (1 – 0.40)] and (2) this cost is 5.4% [0.09 × (1 – 0.40)].
d. Given the circumstances described in part (c), discuss when refunding would be favorable and when it would not.
e. If the two circumstances summarized in your answer to part (d) were equally probable(each had a probability of 50%), would you recommend refunding? Explain your answer.


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  • CreatedMarch 26, 2015
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