Schumann Shoe Manufacturer is considering whether or not to refund a $70 million, 10% coupon, 30-year bond issue that was sold 8 years ago. It is amortizing $4.5 million of flotation costs on the 10% bonds over the issue's 30-year life. Schumann's investment bankers have indicated that the company could sell a new 22-year issue at an interest rate of 8 percent in today's market. Neither they nor Schumann's management anticipate that interest rates will fall below 6 percent any time soon, but there is a chance that interest rates will increase.

A call premium of 10 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Schumann's marginal federal-plus-state tax rate is 40 percent. The new bonds would be issued 1 month before the old bonds are called, with the proceeds being invested in short-term government securities returning5 percent annually during the interim period.

Current bond issue data

Par value .....................................................................$70,000,000

Coupon rate.............................................................................10%

Original maturity ........................................................................30

Remaining maturity ....................................................................22

Original flotation costs .................................................$4,500,000

Call premium ...........................................................................10%

Tax rate ....................................................................................40%

Refunding data

Coupon rate ......................................................................8.0000%

Maturity .....................................................................................22

Flotation costs .............................................................$5,000,000

Before Tax

70,000,000 x.10=7,000,000

After Tax

70,000,000 x 1-T

Time between issuing new bonds and calling old bonds (months) 1

Rate earned on proceeds of new bonds before calling old bonds (annual) 5%

a. Perform a complete bond refunding analysis. What is the bond refunding NPV?

b. At what interest rate on the new debt is the NPV of the refunding no longer positive?