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The Harding Corporation has $$50$ million of bonds outstanding which were issued at a coupon rate of $10\mathrm{.}25$

percent seven years ago. Interest rates have fallen to $9$ percent. Preston Alter, the vice$-$president of finance,

does not expect rates to fall any further. The bonds have $18$ years left to maturity, and Preston would like to

refund the bonds with a new issue of equal amount also having $18$ years to maturity. The Harding Corporation

has a tax rate of $25$ percent. The underwriting cost on the old issue was $2\mathrm{.}5$ percent of the total bond value.

The underwriting cost on the new issue will be $1\mathrm{.}8$ percent of the total bond value. The original bond

indenture contained a five$-$year protection against a call, with an $8$ percent call premium starting in the sixth

year and scheduled to decline by one$-$half percent each year thereafter $($consider the bond to be seven

years old for purposes of computing the premium$).$

Should the Harding Corporation refund the old issue?

Explain the answer.

Answer:

Outflows

Payment on call provision $$3,750,000$

Borrowing expenses of new issue

Actual expenditure $900,000$

Amortization of costs $180,000$

Annual Tax savings $45,000$

Present value of future tax savings $185,751$

Net cost of borrowing expenses of new issue $714,249$

Net outflow $$4,464,249$

Inflows

Cost savings attributed to lower rate:

Annual interest cost of old bond $$5,125,000$

Annual interest cost on new bond $4,500,000$

Savings per year $625,000$

After tax savings per year $468,750$

Present value of annual cost savings $$4,801,477$

Inflow less outflow $($Net Present Value$)$ $$337,227$

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