14: Long-Term Debt and Leasingc Calculate the after-tax cost of the call premium that is required to retire the old bonds.
d Determine the initial investment that is required to call the old bonds and issue the new bonds.
e Calculate the annual cash flow savings, if any, which are expected from the proposed bond
refunding decision.
f If the company has a 4.2% after-tax cost of debt, find the net present value (NPV) of the bond
refunding decision. Would you recommend the proposed refunding? Explain your answer.P14-5 Web Tools Company is considering using the proceeds from a new $50 million bond issue to call
and retire its outstanding $50 million bond issue. The details of both bond issues are outlined in
what follows. The company is in the 40% tax bracket.
Old bonds. The company’s old issue has a coupon interest rate of 10%, was issued four years
ago, and had a 20-year maturity. The bonds sold at a $10 discount from their $1,000 face value,
flotation costs were $420,000, and their call price is $1,100.
New bonds. The new bonds are expected to sell at par ($1,000), have a 16-year maturity, and
have flotation costs of $520,000. The company will have a two-month period of overlapping interest
while it retires the old bonds.
a What is the initial investment that is required to call the old bonds and issue the new bonds?
b What are the annual cash flow savings, if any, from the proposed bond refunding decision if the
new bonds have an 8% coupon interest rate? If the new bonds have a 9% coupon interest rate?
c Construct a table showing the net present value (NPV) of refunding under the two circumstances
given in part (b) when (1) the company’s after-tax cost of debt is 4.8% [0.08 3 (1 – 0.40)] and (2)
this cost is 5.4% [0.09 3 (1 – 0.40)].
d Given the circumstances described in part (c), discuss when refunding would be favourable and
when it would not.
e If the two circumstances summarised in your answer to part (d) were equally probable (each had
a probability of 25%), would you recommend refunding? Explain your answer.
LEASING
P14-6 Given the lease payments and terms shown in the following table, determine the yearly after-tax
cash outflows for each company. Assume that lease payments are made at the beginning of each
year, that the company is in the 40% tax bracket, and that no purchase option exists.
Company Annual lease payment Term of lease (years)
A $ 250,000 5
B 160,000 12
C 500,000 8
D 1,000,000 20
E 25,000 6P14-7 Eastern Transport Company needs to expand its facilities. In order to do so, the company must
acquire a machine costing $80,000. The machine can be leased or purchased. The company is in
the 40% tax bracket, and its after-tax cost of debt is 5.4%. The terms of the lease and purchase
plans are as follows:
Lease. The leasing arrangement requires beginning-of-year payments of $16,900 over five years.
The lessee will exercise its option to purchase the asset for $20,000, to be paid along with the final
lease payment.