The Harding Corporation has $52 million of bonds outstanding that were issued at a coupon rate of 13.25 percent seven years ago. Interest rates have fallen to 11.6 percent. Preston Alter, the vice-president of finance, does not expect rates to fall any further. The bonds have 18 years left to maturity, and Preston would like to refund the bonds with a new issue of equal amount also having 18 years to maturity. The Harding Corporation has a tax rate of 22 percent. The underwriting cost on the old issue was 4.5 percent of the total bond value. The underwriting cost on the new issue will be 1.8 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with an 8 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter (Consider the bond to be seven years old for purposes of computing the premium). Use Appendix D.     a. Compute the discount rate. (Round the final answer to 2 decimal places.)   Discount rate           9.00 ± 2% %   b. Calculate the present value of total outflows. (Enter the answers in whole dollars, not in millions. Round "PV Factor" to 3 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar.)    Total outflows           $ 4,672,168 ± 2%   c. Calculate the present value of total inflows. (Enter the answers in whole dollars, not in millions. Round "PV Factor" to 3 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar.)    Total inflows           $ 5,776,524 ± 2%   d. Calculate the net present value. (Enter the answers in whole dollars, not in millions. Round "PV Factor" to 3 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar. Negative amount should be indicated by a minus sign.)    Net present value           $ 1,104,356 ± 2%   e. Should the Harding Corporation refund the old issue?   multiple choice 2 No YesCorrectCorrect           Explanation   a. Discount rate  r (%I/Y) = 11.6% (1 – 0.23) = 9%   b. Costs (Outflows) 1. Payment of call premium: $52,000,000 × 7.5% =  $3,900,000       2. Borrowing expenses of new issue:    Underwriting cost = 1.8 % × $52 million = $936,000 Amortization of expenses  ($936,000 / 5) (0.23) = $187,200 (0.23) $42,120 tax savings per year           Actual expenditure = $936,000     PV of future tax savings $42,120   @ PVIFA (N = 5, %I/Y = 9%) = (163,832)          Net cost of borrowing expenses of new issue   $772,168             3. No overlap period:    c .      Benefits (Inflows) 4. Cost savings in lower interest rates:           13.25% (Interest on old bond) × $52,000,000 =  $6,890,000     12% (Interest on new bond) × $52,000,000 =  (6,038,710)          Savings per year = $851,290           Aftertax savings per year $851,290.32 × (1 – 0.23) =  $ 659,750   PV of annual aftertax interest savings $659,750/year @ PVIFA (N= 18, %I/Y = 9%) = $5,776,524   d.             Summary Costs   Benefits 1.   $3,900,000       2.   772,168       3.   0     4. $5,776,524               PV of outflows ($4,672,168)    PV of inflows $5,776,524                 NPV (Net present value)  = $1,104,356   e. The Harding Corporation should refund the issue, as the NPV is positive at this time. Can you please explain where they got the 0.23

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
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The Harding Corporation has $52 million of bonds outstanding that were issued at a coupon rate of 13.25 percent seven years ago. Interest rates have fallen to 11.6 percent. Preston Alter, the vice-president of finance, does not expect rates to fall any further. The bonds have 18 years left to maturity, and Preston would like to refund the bonds with a new issue of equal amount also having 18 years to maturity. The Harding Corporation has a tax rate of 22 percent. The underwriting cost on the old issue was 4.5 percent of the total bond value. The underwriting cost on the new issue will be 1.8 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with an 8 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter (Consider the bond to be seven years old for purposes of computing the premium). Use Appendix D.  

 

a. Compute the discount rate. (Round the final answer to 2 decimal places.)

 

Discount rate           9.00 ± 2% %

 

b. Calculate the present value of total outflows. (Enter the answers in whole dollars, not in millions. Round "PV Factor" to 3 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar.) 

 

Total outflows           $ 4,672,168 ± 2%

 

c. Calculate the present value of total inflows. (Enter the answers in whole dollars, not in millions. Round "PV Factor" to 3 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar.) 

 

Total inflows           $ 5,776,524 ± 2%

 

d. Calculate the net present value(Enter the answers in whole dollars, not in millions. Round "PV Factor" to 3 decimal places. Do not round intermediate calculations. Round the final answer to nearest whole dollar. Negative amount should be indicated by a minus sign.) 

 

Net present value           $ 1,104,356 ± 2%

 

e. Should the Harding Corporation refund the old issue?

 

multiple choice 2

  • No
  • YesCorrectCorrect
 
 
 
 
 

Explanation

 

a.

Discount rate  r (%I/Y) = 11.6% (1 – 0.23) = 9%

 

b.

Costs (Outflows)

1. Payment of call premium:

$52,000,000 × 7.5% =  $3,900,000    

 

2. Borrowing expenses of new issue:   

Underwriting cost = 1.8 % × $52 million = $936,000

Amortization of expenses  ($936,000 / 5) (0.23)

= $187,200 (0.23)

$42,120 tax savings per year

 

     
  Actual expenditure = $936,000  

  PV of future tax savings $42,120
  @ PVIFA (N = 5, %I/Y = 9%)

= (163,832) 
     
  Net cost of borrowing expenses of new issue   $772,168  
     
 

 

3. No overlap period:

 

 c .     

Benefits (Inflows)

4. Cost savings in lower interest rates:

 

     
  13.25% (Interest on old bond) × $52,000,000 =  $6,890,000  
  12% (Interest on new bond) × $52,000,000 =  (6,038,710) 
     
  Savings per year = $851,290  
     
 


Aftertax savings per year $851,290.32 × (1 – 0.23) =  $ 659,750

 

PV of annual aftertax interest savings $659,750/year @ PVIFA (N= 18, %I/Y = 9%) = $5,776,524
 

d.

         
  Summary Costs   Benefits
1.   $3,900,000      
2.   772,168      
3.   0     4. $5,776,524  
         
  PV of outflows ($4,672,168)    PV of inflows $5,776,524  
         
 

 

NPV (Net present value)  = $1,104,356

 

e.

The Harding Corporation should refund the issue, as the NPV is positive at this time.

Can you please explain where they got the 0.23

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