Web Tools Company is considering using the proceeds from a new $50 million bond issue to call and retire its outstanding $50 million bond issue. The details of both bond issues are outlined in what follows. The firm is in the 40 percent tax bracket. Old bonds.
The firm's old issue has a coupon interest rate of 10 percent, was issued four years ago, and had a twenty-year maturity. The bonds sold at a $10 discount from their $1,000 par value, floatation costs were $420,000, and their call price is $1,100. New bonds.
The new bonds are expected to sell at par ($1,000), have a sixteen-year maturity, and have floatation costs of $520,000. The firm will have a two-month period of overlapping interest while it retires the old bonds.
a. What is the initial investment required to call the old bonds and issue the new bonds?
b. What are the annual cash flow savings, if any, from the proposed bond- refunding decision if (1) the new bonds have an 8 percent coupon interest rate and (2) the new bonds have a 9 percent coupon interest rate?
c. Calculate the net present value (NPV) of refunding under the two circumstances given in part (b) when (1) the firm has an after-tax cost of debt of 4.8 percent [0.08 (1 - 0.40)] and (2) the firm has an after-tax cost of debt of 5.4 percent [0.09 (1 - 0.40)]. d. Discuss the circumstances [described in part (c)] when refunding would be favorable and when it would not.