Question: Barton Simpson, the chief financial officer of Broadband Inc. could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 6 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago. Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par, and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life. Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.

b. Compare the price in part a to the 8 percent call premium over par value. Which appears to be more attractive in terms of reacquiring the old bonds?

Step by step solution

01

Information available

Single price of par value bond =$1,000

PV of future payments = $1,405

Call premium = 8%

02

Comparison of the answer is part a and a bond that has a call premium of 8%

The bond is currently trading at $1,405 and this value is $405 more than the par value of the bond. The bond is paying around 40% more than the par value and this amount is very high as compared to the 8% call premium. The company should call the bonds instead of repurchasing them in the market.

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