John Whiteck, financial vice president of Fox River Telephone Company, has just begun reviewing the minutes of the companys November 2016 board of directors meeting. The major topic discussed at the meeting was whether Fox River should refund any of its currently outstanding bond issues. Of particular interest is a $50 million, 30-year, 11.5 percent, first-mortgage bond (consisting of 50,000 $1,000 par value bonds) issued approximately five years ago. Four of the board members had taken markedly different positions on the question. At the conclusion of the meeting, Ronald Tire, chairman of the board, asked Whiteck to prepare a report analyzing the alternative points of view. The bonds in question had been issued in January, 2012, when interest rates were still relatively high. It was necessary to issue the bonds at that time, despite the high interest rates, because the company needed to complete the modernization and expansion of its switching facilities outside San Francisco to meet rapidly growing demand for telephone services in its service area. At that time, Whiteck and the board strongly believed interest rates would decline in the future, but they were unsure of when rates would fall or by how much. Now, almost five years later, with lower rates, Fox River can sell A-rated bonds at a coupon rate significantly less than 11.5 percent. Since Whiteck had anticipated a decline in interest rates when he sold the $50 million issue, he had insisted that the bonds be made callable after five years. (If the bonds had not been callable, Fox River would have had to pay an interest rate of only 11.0 percent, a full 50 basis points less than the actual 11.5 percent.) The bonds can be called after January 1, 2017, but an initial call premium of 11.5 percent, or $115 per bond, would have to be paid. This premium declines by 11.5%/25 = 0.46 percentage points, or $4.60, each year. Thus, if the bonds were called in 2022, the call premium would be (0.115/25)(20) = 9.2% or $92, where 20 represents the number of years remaining to the maturity. The flotation costs on this issue amounted to 1.5 percent of the face amount, or $750,000. The firms federal-plus-state tax rate is 40 percent. Whiteck estimates that Fox River can sell a new issue of 25-year bonds at an interest rate of 9.5 percent. The call of the old and the sale of the new bonds could take place five to seven weeks after the decision to refund has been made; this time is required to give legal notice to bondholders and to arrange the $50 million or more needed to pay them off. The flotation cost on the refunding issue would be one percent of the new issues face amount, and funds from the new issue would be available from the underwriters the day they were needed to pay off the old bonds. Whiteck had proposed at the last directors meeting that the company call the 11.5 percent bonds and refund them with a new 9.5 percent issue. (The bonds could not have been called earlier because of the call protection provision in the indenture.) Although the refunding cost would be substantial, he believed the interest savings of 2 percent per year for 25 years on a $50 million issue would be well worth the cost. Whiteck did not anticipate adverse reactions from the other board members; however, four of them voiced strong doubts about the refunding proposal. The first doubt was raised by Trish Esposito, a long-term member of Fox Rivers board and president of Esposito, Arfaras, and Black, an investment banking house catering primarily to institutional clients such as insurance companies and pension funds. Esposito argued that calling the bonds for refunding would not be well received by the major financial institutions that hold the firms outstanding bonds. According to Esposito, the institutional investors that hold the bonds purchased them with the expectation of receiving the 11.5 percent interest rate for at least 10 years, and these investors would be very disturbed by a call after only five years. Since most of the leading institutions hold some of Fox Rivers bonds, and since the firm typically sells new bonds or common stock to finance its growth every two or three years, it would be most unfortunate if institutional investors developed a feeling of ill will toward the company. A second director, Lee Chang, who was a relatively new member of the board and president of a local bank, also opposed the call, but for an entirely different reason. Chang believed that the decline in interest rates was not yet over. He said a study by his bank suggested that the long-term interest rate might fall to as low as 7.5 percent within the next six months. Under questioning from the other board members, however, Chang admitted that the interest rate decline could in fact be over and that interest rates might, very shortly, begin to rise. When pressed, Chang produced the following probability distribution that his economists had developed for interest rates on A-rated utility for January 1, 2018, one year from the pending refunding date:

The third director, Pete Koulianis, requested more information on the refunding. Koulianis suggested that a formal analysis using discounted cash flow (DCF) techniques be employed to determine the profitability of the refunding. As he reflected on Koulianiss proposal, Whiteck wondered whether it would be better to use Fox Rivers cost of debt or its weighted average cost of capital as the discount rate in the analysis. Further, if the cost of debt were used, he wondered whether a before- or after-tax figure should be employed. The fourth director, Tammy Malloy, Fox Rivers treasurer, stated that she was not against the refunding, but wondered whether it was wise to sell the new bonds and call the old bonds essentially at the same time. Malloy was worried that something might go wrong, keeping the company from obtaining the cash generated by the sale of the new bonds in time to pay for the repurchase of the old bonds. Therefore, she suggested that the firm issue the new bonds two to three weeks before the refunding of the old bonds to ensure that sufficient cash is on hand when the old bonds are repurchased. Malloy also pointed out that the funds generated by the sale of the new bonds could be invested in short-term treasury securities yielding 6 percent during this overlap period. Finally, she noted that interest rates had been quite volatile lately and that if rates rose before the new issue could be sold, but after the firm had committed to the refunding, the refunding would be a disaster. Therefore, she wondered if the firm could lock in a profit and thus protect itself against rising interest rates by assuming a position in the futures market.

1. Calculate the NPV of Fox River Telephones proposed bond refunding. 2. What is the importance of each of the four issues raised by members of Fox Rivers board regarding the refunding decision?

Answer rating: 100% (QA)

To answer your questions lets break down the information and calculations needed step by step 1 Calculate the NPV of Fox River Telephones proposed bon... View the full answer