Lecsession

For federal income tax purposes, the unamortized (not-yet-written-off ) issuing expense of

the old bonds, the call premium, and the unamortized discount of the old bonds, if they were

sold at a discount, are deductible as expenses in the year of the refunding. The old bonds were

sold 5 years ago at a $250,000 discount from par value, so the unamortized portion now is

$200,000. Moreover, the legal fees and other issuing expenses involved with the old bonds

have an unamortized balance of $100,000. The call price on the old bonds is 109 ($1,090 per$1,000-face-value bond); issuing expenses on the new bonds are $150,000; the income tax rate

is 40 percent; and there is a 30-day period of overlap. The period of overlap is the lag between

the time the new bonds are sold and the time the old bonds are called. This lag occurs because

most companies wish to have the proceeds from the new issue in hand before they call the old

issue. Otherwise, there is a certain amount of risk associated with calling the old issue and

being at the “mercy” of the bond market in raising new funds. During the period of overlap,

the company pays interest on both bond issues.

Framework for Analysis. With this rather involved background information in mind, we

can calculate the initial cash outflow and the future cash benefits. The net cash outflow at the

time of the refunding is as follows:

Cost of calling old bonds (call price, 109) $21,800,000

Net proceeds of new bond issue 19,600,000

Difference $ 2,200,000

Expenses

Issuing expense of new bonds $ 150,000

Interest expense on old bonds during overlap period 200,000 350,000

Gross cash outlay $ 2,550,000

Less: Tax savings

Interest expense on old bonds during overlap period $ 200,000

Call premium 1,800,000

Unamortized discount on old bonds 200,000

Unamortized issuing expenses on old bonds 100,000

Total...