Submitted by: Submitted by babu1234
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Words: 2703
Pages: 11
Category: Business and Industry
Date Submitted: 02/19/2013 08:13 PM
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...