Schumann Shoe Manufacturer is considering whether or not to refund a $70 million, 10% coupon, 30-year bond issue that was sold 8 years ago. It is amortizing $4.5 million of flotation costs on the 10% bonds over the issue's 30-year life. Schumann's investment bankers have indicated that the company could sell a new 22-year issue at an interest rate of 8 percent in today's market. Neither they nor Schumann's management anticipate that interest rates will fall below 6 percent any time soon, but there is a chance that interest rates will increase.

A call premium of 10 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Schumann's marginal federal-plus-state tax rate is 40 percent. The new bonds would be issued 1 month before the old bonds are called, with the proceeds being invested in short-term government securities returning 5 percent annually during the interim period.

Current bond issue data

Par value

$ 70,000,000

Coupon rate

10%

Original maturity

30

Remaining maturity

22

Original flotation costs

$ 4,500,000

Call premium

10%

Tax rate

40%

Refunding data

Coupon rate

8.0000%

Maturity

22

Flotation costs

$ 5,000,000

Time between issuing new bonds and calling old bonds (months)

1

Rate earned on proceeds of new bonds before calling old bonds (annual)

5%

a. Perform a complete bond refunding analysis. What is the bond refunding's NPV?

Initial investment outlay to refund old issue:

Call premium on old issue =

After-tax call premium =

New flotation cost =

Old flotation costs already expensed =

Remaining flotation costs to expense =

Tax savings from old flotation costs =

You get to expense the remaining flotation costs

Additional interest on old issue after tax =

This is interest paid on the old bond issue between when the new bonds are issued and the old bonds are retired

Interest earned on investment in T-bonds after tax =

This is interest earned on the proceeds from the new bonds before they are used to pay off the old bonds.

Total investment outlay =

Annual Flotation Cost Tax Effects:

Annual tax savings on new flotation =

Tax savings lost on old flotation =

Total amortization tax effects =

Annual interest savings due to refunding:

Annual after tax interest on old bond =

Annual after tax interest on new bond =

Net after tax interest savings =

Annual cash flows =

After-tax cost of new debt =

NPV of refunding decision =

b. At what interest rate on the new debt is the NPV of the refunding no longer positive?

Use Goal Seek to set cell D60 to zero by changing cell C27.

"Break-even" interest rate =