Rainier Bros. has 12.0% semiannual coupon bonds outstanding that mature in 10 years. Each bond is now eligible to be called at a call price of
$1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual "breakeven rate"?

Question

Quizplus · Accepted Answer

The breakeven rate is calculated by equating the cost of calling the old bonds and issuing new ones. The current bonds have a coupon rate of 12% with semiannual payments, and the call price is $1,060. The flotation cost is $45, so the effective cost of issuing new bonds is $1,105 ($1,060 + $45). The breakeven yield to maturity is the rate at which the present value of the new bond payments equals this cost. Calculating this gives a nominal annual rate of 10.29%.