Chapter 5: Q14DQ (page 524)

What cost of capital is generally used in evaluating a bond refunding decision? Why?

Short Answer

Expert verified

The cost of debt is used in evaluating a bond refunding decision because it helps the business determine the outflow of cash as payment of interest to investors.

Step by step solution

Bond refunding

Bond refunding refers to how a corporation redeems itsoutstanding bondscontaining high interests and issues low-interest-rate bonds.

Cost of capital used in bond refunding

The corporations use the cost of debt while making decisions associated with thebond refunding.

The following formula computes the cost of debt:

The usage of the cost of debt facilitates the management to determine the effective interest rate that a corporation requires to pay to its bondholders.

By evaluating the cost of debt, the management decides whether the bond contains a high or low-interest rate. If interest rates are high, management decides to proceed with the bond refunding process.

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Bailey corporation
Income statement
For the year 20X1
Sales (all on credit)	\(42,680,000
Cost of goods sold	\)32,240,000
Gross profit	\(10,440,000
Selling and administrative expenses	\)4,558,000
Operating profit	\(5,882,000
Interest expense	\)600,000
Net income before taxes	\(5,282,000
Taxes	\)2,120,000
Net income	\(3,162,000

Bailey corporation
Balance sheet
As of December 31, 20X1
Assets
Current assets:
Cash	\)250,000
Marketable securities	\(130,000
Accounts receivables	\)6,000,000
Inventory	\(8,300,000
Total current assets	\)14,680,000
Net plant and equipment	\(13,970,000
Total assets	\)28,650,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	\(3,800,000
Notes payable	\)3,550,000
Total current liabilities	\(7,350,000
Long-term liabilities	\)5,620,000
Total liabilities	\(12,970,000
Stockholder’s equity:
Common stock (1,800,000 shares at \)1 par)	\(1,800,000
Capital in excess of par	\)6,300,000
Retained earnings	\(7,580,000
Total stockholder’s equity	\)15,680,000
Total liabilities and stockholder’s equity	$28,650,000

What cost of capital is generally used in evaluating a bond refunding decision? Why?

Short Answer

Step by step solution

Bond refunding

Cost of capital used in bond refunding

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