Bond Refunding Problem - Thompson Enterprises

Thompson Enterprises has $5,000,000 of bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%, and 15 years left to maturity. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations--assume that the firm's tax rate is zero.

The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?

Call premium: $50 Old rate: 12.0%

Flotation cost per bond: $10 Years to maturity: 15

Amount of issue: $5,000,000 Number of bonds: 5,000

Par value of bonds: $1,000

Cost of refunding:

Call premium per bond * number of bonds = $250,000

Flotation cost = $10 * Number of bonds issued = $ 50,000

Total investment outlay: $300,000

Interest on old bond per year = Old rate * Amount = $600,000

If the company does not call the bonds, it will have to pay $600,000 per year for 15 years, plus $5,000,000 at Year 15. If it goes ahead and calls the bonds, it will have to pay $300,000 + $5,000,000 = $5,300,000 today. We can find the discount rate that equates these cash flows. Here is the time line:

0 1 2 3 ... 15

−300000 $600,000 $600,000 $600,000 $ 600,000

−5000000 $5,000,000

−5300000 600000 600000 600000 $5,600,000

If you enter these cash flows in the cash flow register of a calculator and then press the IRR key, you will get the breakeven rate, which is 11.1583%, rounded to 11.16%. You can do the same thing with Excel. Note that the annual savings at this lower rate would be (0.12 − 0.111583) × $5,000,000 = $42,084.78. The PV of that amount, discounted back for 15 years at 11.16%, is $300,000.

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