Colin Loughman

Bond Refunding Process

Example Problem
Loughman Corporation has a $10 million dollar bond obligation outstanding which it is
considering refunding. Though the bonds were initially issued at 10%, the interest rates on
similar issues have declined to 7.5%. The bonds were originally issued for 20 years and have 10
years remaining. The new issue would be for 10 years. There is a 10% call premium on the old
issue. The underwriting cost on the new $10,000,000 issue is $250,000, and the underwriting
cost on the old issue was $500,000. The company is in a 30% tax bracket, and will use a 5%
discount rate (rounded aftertax cost of debt) to analyze the refunding decision. (Solved on last
page)

Step 1:
You want to start this problem by finding the payment of call premium. You take the call
premium percentage and multiplying it by the bond obligation outstanding.

Step 2:
Next, you want to take the number you got and plug it into the cost of debt formula. You will
also need the tax percentage the company is under. After you solve that you get the net cost of
call premium.

Step 3:
After that you solve for the net cost of underwriting expense. You take the value of the
underwriting cost of the new bond and then divide that by the amount of years the bond has
remaining.

Step 4:
Now you take the number you got in the previous step, and then multiply it by the tax bracket
percentage. This gives you the amount of money the company is saving each year.

Step 5:
Then you take the number in savings per year and multiply it by the present value of annuity
chart. This gives you the present value of future tax savings.

Step 6:
The next number we want to solve for is the net cost of underwriting expenses. You take the
underwriting cost of new issues and subtract the present value of future tax savings.

Step 7:
Finally, we solve for the present value of outflows. You get the present value of outflows from
adding the net cost of call premium and the net cost of underwriting expenses.
Step 8:
Now that we have the outflow, we solve for the inflows. The first inflow we solve for is the cost
savings in lower interest rates. You take both of the interest rate percentages of the new and
old and multiply them by the bond obligation price. Then you subtract the new from the old.

Step 9:
These savings are tax deductible. You use the cost of debt formula once again and once you get
that number you multiply it by the same present value of annuity number we had before.

Step 10:
You take the old underwriting cost, and divide it by the total amount of years. Then you
multiply it by the difference in years on the old and new issues. Then you take the original
amount and subtract it by the value you just calculated. This gives you the unamortized old
underwriting cost.

Step 11:
Next, we find the present value of the yearly value of unamortized old underwriting cost. It’s
solved for by taking the unamortized old underwriting cost just found and dividing it by the
remaining life. Then you take that value and once again multiply it by present value of annuity
chart value. After getting that you subtract the present value of future write off from the
immediate write off. This gives you the gain from immediate write off.

Step 12:
Then you multiply the gain from immediate write-off by the tax rate to get the net gain from
the underwriting on the old issue of the bond.

Step 13:
Now get the present value of inflows by adding the cost of savings in lower interest rates and
the net gain from the underwriting on the old issue. Then you get the present value of outflows
and subtract it from the inflows. This gives you the net present value and determines if the
company would make or lose money.