Loose Cannon Co.
Loose Cannon Co. is evaluating a new $75 million bond issue, the proceeds of which would be used to call and retire its outstanding $75 million bonds. Details on both bond issues are presented below. The firm is in the 35% tax bracket.
Old Bonds The old issue sold at par, with a coupon rate of 11 percent. It was issued five years ago with a twenty year maturity. The issue had $350,000 in flotation costs and carries a call price of $1150.
New Bonds The new issue are expected to sell at par with an 8.5 percent coupon rate and a 15 year maturity. Flotation costs are forecast to be $500,000. Interest payments will overlap for 2 months while the old bonds are retired.
-Refer to Loose Cannon Co.What is the initial investment required to refund the bonds?

Question

Quizplus · Accepted Answer

To determine the initial investment required to refund the bonds, we need to calculate the cost of retiring the old bonds and issuing the new bonds.

First, we need to calculate the cost of retiring the old bonds:
Call price per bond = $1,150
Number of old bonds = $75,000,000 / $1,000 = 75,000
Cost of retiring old bonds = $1,150 x 75,000 = $86,250,000

Next, we need to calculate the cost of issuing the new bonds:
Flotation costs = $500,000
Number of new bonds = $75,000,000 / $1,000 = 75,000
Net proceeds from new bond issue = $75,000,000 - $500,000 = $74,500,000
Annual interest payment on new bonds = $74,500,000 x 8.5% = $6,332,500
Interest payments will overlap for 2 months, so the total interest payment during the overlap period is:
= ($6,332,500 / 12) x 2 = $1,055,417
Total cost of issuing new bonds = Flotation costs + Cost of interest payments during overlap period = $500,000 + $1,055,417 = $1,555,417

Therefore, the total initial investment required to refund the bonds is:
$86,250,000 + $1,555,417 = $87,805,417

The best choice is B, as it has the lowest initial investment required to refund the bonds.

Loose Cannon Co. Loose Cannon Co. Is Evaluating a New $75 Million Bond