The Bowman Corporation has a bond obligation of $27 million outstanding, which it is considering refunding. Though the bonds were initially issued at 12 percent, the interest rates on similar issues have declined to 10.9 percent. The bonds were originally issued for 20 years and have 10 years remaining.

The Bowman Corporation has a bond obligation of $27 million outstanding, which it is considering refunding. Though the bonds were initially issued at 12 percent, the interest rates on similar issues have declined to 10.9 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a call premium of 8 percent on the old issue. The underwriting cost on the new $27,000,000 issue is $570,000, and the underwriting cost on the old issue was $460,000. The company is in a 35 percent tax bracket, and it will use an 9 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision. Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

a.	Calculate the present value of total outflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)

  

PV of total outflows

$

  

b.	Calculate the present value of total inflows. (Do not round intermediate calculations and round your answer to 2 decimal places.)

  

PV of total inflows

$

  

c.	Calculate the net present value. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)

  

Net present value

$

  

d.	Should the old issue be refunded with new debt?
	No

 
Explanation:

a.
Net cost of call premium	= (Call premium rate × Face value of issue) × (1 – Tax rate)
	= (.08 × $27,000,000) × (1 – .35)
	= $1,404,000
Underwriting expenditure	= Underwriting cost New issue
	= $570,000
Annual tax savings New issue	= (Underwriting cost New issue / Issue years) × Tax rate
	= ($570,000 / 10) × .35
	= $19,950
PV of tax savings New issue	= Annual tax savings  New issue × ({1 – [1 / (1 + i)n]} / i)
	= $19,950 × ({1 – [1 / (1.09)10]} / .09)
	= $128,032.27

   

PV of cash outflows	= Net cost of call premium + Underwriting expenditure New issue – PV of tax savings New issue
	= $1,404,000.00 + 570,000.00 – 128,032.27
	= $1,845,967.73
b.
Net annual interest savings	= (Initial interest rate – Current interest rate) × Face value of issue × (1 – Tax rate)
	= (.12 – .109) × $27,000,000 × (1 – .35)
	= $193,050

   

PV of interest savings	= Net annual interest savings × ({1 – [1 / (1 + i)n]} / i)
	= $193,050 × ({1 – [1 / (1.09)10]} / .09)
	= $1,238,928.82
Annual amortization Old issue	= Underwriting cost Old issue/ Issue years
	= $460,000 / 20
	= $23,000
Unamortized cost Old issue	= Cost Old issue  – (Annual amortization × Number of years since issuance)
	= $460,000 – ($23,000 × 10)
	= $230,000
PV of unamortized cost Old issue	= Annual cost Old issue × ({1 – [1 / (1 + i)n]} / i)
	= $23,000 × ({1 – [1 / (1.09)10]} / .09)
	= $147,606.13

Immediate gain in unamortized cost Old issue	= Unamortized cost Old issue – PV of unamortized cost Old issue
	= $230,000 – 147,606.13
	= $82,393.87

Cost tax savings Old issue	= Immediate gain in unamortized cost Old issue × Tax rate
	= $82,393.87 × .35
	= $28,837.86
PV of cash inflows	= PV of interest savings + Cost tax savings Old issue
	= $1,238,928.82 + 28,837.86
	= $1,267,766.68
c.
Net present value	= PV of cash inflows – PV of cash outflows
	= $1,267,766.68 – 1,845,967.73
	= –$578,201.05

  

d. Since the NPV is negative, the old issue should not be refunded.

  

Calculator Solution:

  

	N			I/Y			PV			PMT			FV
10			9			CPT PV –128,032.27			19,950			0

  

	N			I/Y			PV			PMT			FV
10			9			CPT PV –1,238,928.82			193,050			0

  

	N			I/Y			PV			PMT			FV
10			9			CPT PV –147,606.13			23,000			0

Appendix Solution:

The time value calculations using the tables are shown below. If you use these approximation values, your answers will vary somewhat from those shown above.

PV of tax savings New issue	= Annual tax savings New issue  × PVIFA (9%, 10)
	= $19,950 × 6.418
	= $128,039.10

PV of interest savings	= Net annual interest savings  × PVIFA (9%, 10)
	= $193,050 × 6.418
	= $1,238,994.90

PV of unamortized cost Old issue	= Annual costOld issue  × PVIFA (9%, 10)
	= $23,000 × 6.418
	= $147,614.00