The Robinson Corporation has $50 million of bonds outstanding that were issued at a coupon rate of 11 3/4 percent seven years ago. Interest rates have fallen to 10 3/4 percent. Mr. Brooks, the vice president of finance, does not expect rates to fall any further. The bonds have 18 years left to maturity, and Mr. Brookswould like to refund the bonds with a new issue of equal amount also having 18 years to maturity.
The Robinson Corporation has a tax rate of 35 percent. The underwriting cost on the old issue will be 1.8 percent of the total bond value. The original bond indenture contained a five year protection against a call, with a 9.5 percent call premium starting in the sixth year and scheduled to decline be one-half percent each year thereafter. (Consider the bond to be 7 years old for purposes of computing the premium.) Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole number.
(a) Given a 7% discount rate, calculate the cost savings from lower interest rates Robinson would realize if Robinson refinanced (i.e., refund) its long term debt. Show work. (Note: only calculate the cost savings from lower interest rates, don't solve the whole problem.)
(b) Would an S&P downgrade tend to result in more bond refunding or less? Explain.
(c) When making a refunding decision, what would be most useful; knowing payback, IRR, or NPV? Explain.