Chapter 5: Q18BP-a (page 530)

Question: The Robinson Corporation has $43 million of bonds outstanding that were issued at a coupon rate of 11¾ percent seven years ago. Interest rates have fallen to 10¾ percent. Mr. Brooks, the vice president of finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 2.4 percent of the total bond value. The underwriting cost on the new issue will be 1.7 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a 9 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.) Assume the discount rate is equal to the after-tax cost of new debt rounded up to the nearest whole number.
a. Compute the discount rate.

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Answer

The discount rate is 8%.

Step by step solution

Bond obligation = 43,000,000

Interest rate at the time of issue = 11¾%

Interest rate after decline = 10¾%

Time remaining of bonds = 17 years

Call premium on old issue =9%

Underwriting cost of new issue =1.7% of total bond value

Underwriting cost on old issue = 2.4% of total bond value

Tax rate = 30%

The discount rate is 7.53% and this rate is rounded to 8%.

$D i s c o u n t r a t e = D e c r e s e d i n t e r e s t r a t e \times (1 - T a x r a t e) = 10.75 % (1 - 30 %) = 7.53 %$

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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