Leyland Enterprises has $5,000,000 in bonds outstanding.The bonds each have a maturity value of $1,000, an annual coupon of 12 percent, and 15 years left until maturity.The bonds can be called at any time at a call price of $1,100 per bond.If the bonds are called, the company must pay flotation costs of $50,000 ($10 for every $1,000 of bonds outstanding).Ignore tax considerations.Assume that the tax rate is zero.The company's decision whether to call the bonds depends critically on the current interest rate it would pay on new bonds issued.What is the breakeven interest rate, below which it is profitable to call in the bonds?

Question

Quizplus · Accepted Answer

The breakeven interest rate is the rate at which the present value of the call price plus the flotation costs equals the present value of the remaining coupon payments plus the maturity value. In this case, the call price is $1,100 per bond, the flotation costs are $50,000, the remaining coupon payments are $120 per bond per year for 15 years, and the maturity value is $1,000 per bond. The present value of the call price plus the flotation costs is $1,150 per bond. The present value of the remaining coupon payments plus the maturity value is $1,257.30 per bond. Therefore, the breakeven interest rate is the rate at which the present value of the call price plus the flotation costs equals the present value of the remaining coupon payments plus the maturity value, which is 10.51%.

Leyland Enterprises Has $5,000,000 in Bonds Outstanding