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Less: Tax-deductible items

Interest

Amortization of issue cost

10,OoO

($150,000/15 years)

$810,000

Total tax-deductible items

x 0.46

Tax rate

372,600

Tax savings

$427,400

Annual cash outflow with new bond

The net annual cash savings with the new bond compared to the old bond is:

$5 14,700

Annual cash outflow with old bond

427,400

Annual cash outflow with new bond

$ 87,300

Net annual cash savings

The net present value associated with the refunding is:

Calculation Present Value

Year 0 -$175,500 X 1 -$175,500

Years 1-15 $87,300 X 10.38" +906,174

$730,674

Net present value

"Present value of annuity factor for i = 5 % , n = 15.

Since a positive net present value exists, the refunding of the old bond should be made.

363

LONG-TERM DEBT

CHAP. 141

Sinking fund requirements may exist with regard to a bond issue. With a sinking fund, the company

is required to set aside money to purchase and retire a portion of the bond issue each year. Usually, there

is a mandatory fixed amount that must be retired, but occasionally the retirement may relate to the

companyâ€™s sales or profit for the current year. If a sinking fund payment is not made, the bond issue may

be in default.

In many cases, the company can handle the sinking fund in one of the following two ways:

1. It can call a given percentage of the bonds at a stipulated price each year, for example, 5 percent

of the original amount at a price of $1,080.

2. It can buy its own bonds on the open market.

The least expensive alternative should be selected. If interest rates have increased, the price of the

bonds will have decreased, and the open market option should be used. If interest rates have decreased,

the bond prices will have increased, and so calling the bonds is the preferred choice.

EXAMPLE 14.12 XYZ Company has to reduce bonds payable by $300,000. The call price is 104.The market price

of the bonds is 103. The company will elect to buy back the bonds on the open market because it is less expensive,

as indicated below.

$312,000

Call price ($300,000 X 104%)

Purchase on open market

309.000

($300,000 X 103%)

Advantage of purchasing bonds

on the open market 3,000

$

Review Questions

1. A(n) mortgage prohibits the company from issuing further debt of the same

priority against the property.

2. A(n) is the written agreement specifying the terms of a bond issue.

3. A(n) clause in a bond agreement prevents the issuance of new debt having

priority over existing debt.

4. Bonds are stated in $ denominations.

5. The interest payment based on the face value of a bond is called interest.

6. As the maturity date of a bond lengthens, the interest rate

7. When a bond is sold at an amount in excess of its face value, it is sold at a(n)

8. A(n) is an unsecured bond.

9. A(n) bond pays interest only if the issuer has earnings.

10. Bond issues that mature periodically are called bonds.

LONG-TERM DEBT

364 [CHAP. 14

times in that the company will be

11. The issuance of bonds has an advantage in

dollars.

paying back the debt in

provision enables the firm to buy back bonds at a date prior to maturity.

12. A(n)

is tax-deductible, whereas dividends are not.

13.

(1) closed-end; (2)indenture; (3) negative pledge; (4) 1,000; (5) nominal; (6) increases; (7) premium;

Answers:

(8) debenture; (9) income; (10) serial; (11) inflationary, cheaper; (12) call; (13) Interest.

Solved Problems

Interest. A company issues a $300,000,10 percent, 20-year bond. The tax rate is 40 percent. What

14.1

is the after-tax semiannual interest dollar amount?

SOLUTION

$300,000 x 10% X = $15,000 (before taxes)

$15,000 X 60% $9,000 (after taxes)

=

Bond Issuance. Boxer Corporation issues a $300,000,16 percent, 10-year bond at 108.

14.2

( a ) What is the maturity value? (6) What is the annual cash interest payment? (c) What are

the proceeds the company receives upon issuance of the bond? (d) What is the amount of the

premium? (e) What is the annual premium amortization?

SOLUTION

$300,000

(a)

16% X $300,000 = $48,000

(b)

108% x $300,000 = $324,000

(4

$324,000 - $300,000 = $24,000

(4

Amortization. A bond with a face value of $200,000 with a 20-year life was sold at 105. The tax

14.3

rate is 35 percent. What is the after-tax effect of the premium amortization?

SOLUTION

Total premium is:

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