Case 25 Case 25 - Warner Motor Oil Company Sing Thomas was concerned about the effect that high interest expenses were having on the bottom line reported profits of Warner Motor Oil Co . Since joining the company threey ears ago as vice president of finance , she noticed that operating profits appeared to be improving each year , but that earnings after ings aft interest and taxes were declining because of high interest charges Because interest rates had finally started declining after a steady increase , she thought it was time to consider the possibility of refunding a bon dissue . As she explained to her boss , A Rosen , refunding meant alling in a bond that had been issued at a high interest rate and replacing it with a new bond that was Similar in most respects , but carried a lower interest rate . Bond refunding was only feasible in a period of carried a ! declining interest rates . Al Rosen , who had been the he CEO of the company for the last seven years understood the general concept , but he still had some questions He said to Gina , " if interest rates are going down 1 . bond prices are certain to be going up . Won't that make it quite expensive to buy My outstanding issues so that we can replace them with new issues ? " Gina had a quick and direct answer . " No , and the reason is that the old i and the reason is that the old issues have a call provision associated with them . " A call provision allo sion allows the firm to call in bonds at slightly over par ( usually & to 10 percent above par ) regardless of what the market price is The Proposed Refunding Decision Gina thought if she could present a specific example to leto Al he would have a better feel for the bond refunding process . She proposed to call in an 1 1 . 50 percent $30 060 ,000 issue that was scheduled to mature in the year 2030 . The bonds had been issued in 2010 and since it w nice it was now 2015 , the bonds had 15 years remaining to maturity . It was Gina's intent to replace the bonds with a new 830 000,100 issue that would have the maturity date 15 years into the future as that of the original 2010 issue . Based on advice from the firm investment banking firm , Walston al alston and Sons , the bonds could be issued at a rate of 10 percent . Joe Walston senior partner in the investment banking firm , further indicated that the underwriting cost on the new issue would be 28 percent of the $30 000.000 amount involved Before she could do her analysis nalysis , Gina needed to accumulate information on the old 1 . 50 percent bond issue that she was proposing to efund . The original bond indenture indicated that the bonds had an 8 percent call premium , and that the bonds could be called anytime after five years Gina explained to Al Rosen that the bondholders were protected from having their bonds called in for the first five years after issue , but that the bonds were fair game after that . Furthermore , from the sixth through the 13 " year , the call premium went down by 1 percent per year By the 14 " year after issue , there w as no call premium and the corporation could merely call in the bonds at par . Since in this case five years had passed , the call premium would be exactly eight percent Gina knew that the underwriting cost on the old issue was important to the calculations related to the refunding decision . She checked with the chief accountant and found out they had initially been $400 000 The firm was currently paying taxes at a rate of 30 percent and would use a discount rate of 7 percent for bond refunding decisionsace them with new issues ? " Gina had is touts su that we can replace them with and the reason is that the old issues have a call p firm to call I provision associated with Required Before you do the bond refunding analysis , determine what the current price of the old bonds would be for the previously issued bonds in the marketplace . Do the example based on a $1 090 bond using semiannual analysis . As specified in the case , the bonds have 15 years remaining . The interest rate at the time of issue was 1 1.50 percent , but is now 10 percent As a result of paying the 8 percent call premium over par instead of the market price determined in question I , how much will the firm save on each old $1 ,000 bond in reacquiring it ? Using the four steps outlined in Chapter 16 of the text for a bond refunding decision , determine whether the potential refunding has a positive net present value . ( Ro und all values to the nearest dollar ) 4 . Assuming you did your calculations correctly in question 3 , you shout " should have gotten a positive net present value . If not , you will want to rerun your numbers . Now assume Gina goes to Al Rosen with these numbers and suggests they do the refunding because there is a positive net present value . What is an additional important consid sideration that Gina and Al must consider before they go ahead with the refunding and a inding and all the associated costs ? Assume that before Warner Motor Oil Company mpany can get the refunding completed , interest rates on new IS year bonds goes up to 10 . 4 percent . Assume all other numbers previously given are the ame , should the refunding be undertaken