Charles River Associates is considering whether to call either of the two perpet
ID: 2382519 • Letter: C
Question
Charles River Associates is considering whether to call either of the two perpetual bond issues the company currently has outstanding. If the bond is called, it will be refunded, that is, a new bond issue will be made with a lower coupon rate. The proceeds from the new bond issue will be used to repurchase one of the existing bond issues. The information about the two currently outstanding bond issues is:
Bond A
Bond B
Coupon Rate
7%
8%
Value outstanding
$131,000,000
$138,000,000
Call premium
7.4%
8.1%
Transaction cost of refunding
$12,100,000
$16,000,000
Current YTM
6.25%
7.0%
The corporate tax rate is 35 percent.
What is the NPV of the refunding for each bond?
NPV for Bond A is
NPV for Bond B is
Which, if either, bond should the company refinance?
A) Bond A
B) Bond B
C) Refund both bonds
D) Neither bond
Bond A
Bond B
Coupon Rate
7%
8%
Value outstanding
$131,000,000
$138,000,000
Call premium
7.4%
8.1%
Transaction cost of refunding
$12,100,000
$16,000,000
Current YTM
6.25%
7.0%
Explanation / Answer
Assume the call Premium is Tax deductible
NPV for Bond A is
Annual Saving in Interest Expenses after tax = (131000000*(7%-6.25%))*(1-35%)
Annual Saving in Interest Expenses after tax = $ 638,625
Transaction cost of refunding = $12,100,000
Call premium = 131000000*7.4% = $ 9,694,000
Tax Saving on (Call premium & Transaction cost of refunding) = (12100000+9694000)*35%
Tax Saving on (Call premium & Transaction cost of refunding) = $ 7,627,900
NPV for Bond A = - Transaction cost of refunding - Call premium + Annual Saving in Interest Expenses after tax/Current YTM + Tax Saving on (Call premium & Transaction cost of refunding)/(1+Current YTM)
NPV for Bond A = -12100000-9694000 + 638625/6.25% + 7,627,900/1.0625
NPV for Bond A = - 4,396,800
NPV for Bond B is
Annual Saving in Interest Expenses after tax = (138000000*(8%-7%))*(1-35%)
Annual Saving in Interest Expenses after tax = $ 897000
Transaction cost of refunding = $16,000,000
Call premium = 138000000*8.1% = $ 11,178,000
Tax Saving on (Call premium & Transaction cost of refunding) = (16000000+11178000)*35%
Tax Saving on (Call premium & Transaction cost of refunding) = $ 9,512,300
NPV for Bond B = - Transaction cost of refunding - Call premium + Annual Saving in Interest Expenses after tax/Current YTM + Tax Saving on (Call premium & Transaction cost of refunding)/(1+Current YTM)
NPV for Bond B = -16000000-11178000 + 897000/7% + 9512300/1.07
NPV for Bond B = - 5,473,714
Which, if either, bond should the company refinance?
D) Neither bond