Problem:
Mike Garcia, the chief financial officer of Endicott Publishing Co., could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 8%. The $30 million, 15 year bond issue that his firm has outstanding was initially issued at 11% five years ago.
Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 10%. The underwriting cost of the old issue had been 3% of par and on the new issue, it would be 4% of par. The tax rate would be 40% and a 5% discount rate would be applied for the refunding decision. The new bond would have a 10 year life.
Before Mike used the 10% call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.
1) First compute the price of the old bonds in the open market. Use the valuation procedures for a bond (Use annual analysis). Determine the price for a single $1,000 par value bond.
2) Compare the price in part a to the 10% call premium over par value. Which appears to be more attractive in terms of reacquiring the old bonds?
3) Now do the standard bond refunding analysis. Is refunding financially feasible?
4) In terms of the refunding decision, how should Mike be influenced if he thinks interest rates might go down even more?