Gina Thomas was concerned about the effect that high interest expenses were having on the bottom-line reported profits of Warner Motor Oil Co. Since joining the company three years ago as vice-president of finance, she noticed that operating profits appeared to be improving each year, but that earnings after interest and taxes were declining because of high interest charges.
Because interest rates had finally started declining after a steady increase, she thought it was time to consider the possibility of refunding a bond issue. As she explained to her boss, AI Rosen, refunding meant calling in a bond that had been issued at a high interest rate and replacing it with a new bond that was similar in most respects, but carried a lower interest rate. Bond refunding was only feasible in a period of declining interest rates. AI Rosen, who had been the CEO of the company for the last seven years, understood the general concept, but he still had some questions.

He said to Gina, "If interest rates are going down, bond prices are certain to be going up. Won't that make it quite expensive to buy in outstanding issues so that we can replace them with new issues?" Gina had a quick and direct answer. "No, and the reason is that the old issues have a call provision associated with them." A call provision allows the firm to call in bonds at slightly over par (usually 8 to 10 percent above par) regardless of what the market price is.
Gina thought if she could present a specific example to Al he would have a better feel for the bond refunding process. She proposed to call in an 11.50 percent $30,000,000 issue that was scheduled to mature in the year 2030. The bonds had been issued in 2010, and since it was now 2015 the bonds had 15 years remaining to maturity. It was Gina's intent to replace the bonds with a new $30,000,000 issue that would have the same maturity date 15 years into the future as that of the original 2010 issue. Based on advice from the firm's investment firm, Walston and Sons, the bonds could be issued at a rate of 10 percent. Joe Walston, a senior partner in the investment firm, further indicated that the underwriting cost on the new issue would be 2.8 percent of the $30,000,000 amount involved.
Before she could do her analysis, Gina needed to accumulate information on the old 11.50 percent bond issue that she was proposing to refund. The original bond indenture indicated that the bonds had an 8 percent call premium, and that the bonds could be called anytime after five years. Gina explained to Al Rosen that the bondholders were protected from having their bonds called in for the first five years after issue, but that the bonds were fair game after that. Furthermore, from the sixth through the 13th year, the call premium went down by 1 percent per year. By the 14th year after issue, there was no call premium and the corporation could merely call in the bonds at par. Since in this case five years had passed, the call premium would be exactly 8 percent.
Gina checked with the chief accountant and found out that the underwriting cost on the old issue had initially been $400,000. The firm was currently paying taxes at a rate of 30 percent.
Outline the considerations in whether or not to refund this bond issue. What must Gina present to Al Rosen? Will Gina achieve her original objective?