Quiz #10 - Chapter 16

Question 1 (35 marks)

Dewey, Cheetham, and Howe Ltd. has had several successful years and greatly improved their financial position. As the
new vice-president of finance, you are considering refinancing existing bonds with a new issue.

You note in particular a bond issue that has the following details:
Maturity value of bond issue $ 66,000,000
Time to maturity (in years) 12
Time since initial bond issue (in years) 8
Annual coupon rate on existing bond 10.0%
Call Premium
No call allowed during the first 5 years
Starting call premium in year 6 12%
Call premium declines by 0.5% per year staring in year 7
Current long-term interest rates on similar bonds 8.500%
Current short-term interest rates 3.0%
Overlap period (in months) 1
Corporate tax rate 31%
Underwriting and other issue costs $ 900,000

Should the old issue be refunded and replaced with a debt issue with a comparable maturity and a coupon rate equal to
that currently in effect on similar bonds? Show your calculations.

STEP 1

Discount rate = After cost of new debt

Interest rate for the new bond 8.50%

Flotation cost of new bond $ 900,000

Flotation cost of new bond as percentage = 900,000/ 66,000,000 1.36%

Before Tax cosf of new debt = 8.5/(1-0.0136)= 8.62

Tax Rate = 31%

After tax cost of new debt = 8.62*(1-0.31) 5.95

Discount rate 5.95%

STEP 2
Present Value PV of total outflows :

Investment Outlay :

Call Premium on old issue = 9.5% (10.5% in year 7, 10% in year 8, 9.5% in year 9 )

Before tax call premium paid on old bond = 66,000,000*9.5% 6270000.00

After tax call premium paid on old bond = 6270000*(1-0.31) 4326300.00

Flotation cost on new bond = 900000.00

Before tax cost of short term borrowing = 66,000,000*3%*(1/12) (1month=1/12 year) 165000.00

After tax cost of short term borrowing =165000*(1-0.31) 113850.00

Present Value PV of total outflows : (4326300+900000+113850) 5,340,150.00

STEP 3

Present Value PV of total Inflows :

After tax interest saving on old issue= 66000000*10%*(1-0.31) 4554000.00

After tax interest cost on new bond= 66000000*8.5%*(1-0.31) 3870900.00

Net Annual Interest Savings (4554000-3870900) 683100.00

Net Annual Cash Inflows = PMT=I 683100.00

Discount Rate = Step 1 5.95%

Number of Years = Nper 2

Present Value PV of Total Inflows = PV $1,253,268.60

Net Present Value

NPV = 1253268.60-5340150
($4,086,881.40)

Net Present Value is negative company should not perform refunding

 Question 2 (35 marks)
Dr. Emmett Brown Inc. has decided to acquire a time machine (instead of building another one). The details on this
purchase follow.

Cost of time machine $ 78,000

Expected useful life of time machine 5
Salvage value at end of useful life $ 11,000

Dr. Brown has two options on how to finance the time machine. Chili Palmer has agreed to advance funds for the
entire purchase price, with the loan being payable in equal instalments at the end of each year over the five years.

The interest rate on this loan would 8.50%

be

As an alternative, the machine could be leased over its useful life from the manufacturer with equal annual lease
payments payable at the beginning of each
year.
Annual lease payment $12,000
Additional information is as follows:
Dr. Emmett Brown Inc’s tax rate 35%
CCA rate for time travel machines 30%
Annual maintenance costs (if Dr. $ 1,800

Should the machine be leased or purchased? Show all calculations.

In case of purchase,

Annual Installment is given by

A = 78000*0.085/(1-1/1.085^5) = $19793.73

Annual Interest schedule is given by

Loan Amount at Principal amount

Year Interest Charge Annual Installment
beginning of year paid

1 78000 6630 19793.73 13163.73

2 64836.27 5511.08295 19793.73 14282.647
3 50553.623 4297.05795 19793.73 15496.672
4 35056.9509 2979.84083 19793.73 16813.889
5 18243.0617 1550.66025 19793.73 18243.07
6 0
Net Cost paid is shown below

Purchase
Year 0 1 2 3 4 5
Depreciation 23400 16380 11466 8026.2 5618.34
Maintenance Cost 1800 1800 1800 1800 1800
Interest cost 6630 5511.083065 4297.06 2979.84 1550.66
Total Costs 31830 23691.08307 17563.06 12806.04 8969
Total Aftertax cost 20689.5 15399.20399 11415.989 8323.926 5829.85
Less: Depreciation 23400 16380 11466 8026.2 5618.34
Principal amount paid 13163.73 14282.65 15496.67 16813.89 18243.07
Machine cost 78000
After tax salvage value 11000
Net Cost paid 10453.23 13301.85399 15446.659 17111.616 7454.58

Present value of Costs at after tax cost of debt( discount rate) ie.8.5%*(1-0.35)= 5.525%

10453.23/1.05525+13301.85/1.05525^2+15446.66/1.05525^3+ 17111.62/1.0525^4+7454.58/1.05525^5

54638.08

In case of Lease

After tax lease payment = $12000* (1-0.35) = $7800

So,

Present value of Costs at after tax cost of debt( discount rate) ie.8.5%*(1-0.35)= 5.525%

7800/0.05525*(1-1/1.05525^5)*1.05525

35124.41

As the Present value of costs in Leasing is less, the machine should be leased