Bond Refunding Problem for Finance Class?

A firm is looking at its capital structure & trying to determine if any value creating changes are available. You must make a recommendation

Cost of capital = 10% - (debt-to-assets ratio)*(.06)*(1.1/1.06)*(net-benefit-to-...

Net-benefit-to-leverage= T* = 0.35*LN (2.9 鈥?3L)

L=leverage ratio
LN=represents the natural logarithm

Market value of firm鈥檚 debt=$45 million

mkt value of common equity=$55 million; firm' stock currently sells for $11/share.

Except for 1 bond issue, all debt of firm is floating rate. The 1 fixed rate issue has face value of $20M &offers 7% coupon (semiannually). The bonds current & call price=105. The bonds mature in 29 yrs. The bonds can be refunded, in whole or part, w/an otherwise identical issue that pays 6% coupon

Unamortized issue costs related to the original bond issue are $500K & new issue requires $1M in underwriting fees regardless size of replacement issue

Determine if the firm should refund issue & if so entire issue or just part it?

The cost of capital equation is supposed to end with (net-benefit-to-leverage)

If anyone knows how to analyze this problem can you please leave a comment or send me an email.

I'm not necessarily asking for the answer, so much as asking for a way to set up the analysis!

Thanks!

The first step is to compute the present value of the 7% bond's cash flows assuming that it is not called. To do this, lay out the cash flows for the next 29 years & discount them at the yield. Since they can issue a new bond at 6%, the yield shold be 6%.

You will find that the present value of those cash flows is about $22.753MM

Since the call price is 105, they can buy back the bonds for 105% of the face value -- or $21MM. If there were no other charges, they would save $1.753MM by refunding the bond.

There isn't enough information to tell -- but it seems that the unammortized issue costs of the original bond are a sunk cost -- so they would be ignored in the analysis. The only other cost is the $1MM issue fee. It would make sense to pay $1MM in order to save $1.753MM.

They should refund the bond -- all of it.

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