Chapter 16: Long-Term Debt and Lease Financing
Present value of principal payment at maturity
PV = FV × PVIF (n = 20*, i = 6%)
Total present value
Present value of interest payments $401.45
b. Purchase price $1,000.00
Chapter 16: Long-Term Debt and Lease Financing
16-22
17. Advanced Refunding decision (LO3) The Bowman Corporation has a $20 million bond
obligation outstanding, which it is considering refunding. Though the bonds were initially
issued at 12 percent, the interest rates on similar issues have declined to 10.5 percent. The
bonds were originally issued for 20 years and have 15 years remaining. The new issue
would be for 15 years. There is an 8 percent call premium on the old issue. The
underwriting cost on the new $20,000,000 issue is $570,000, and the underwriting cost on
the old issue was $400,000. The company is in a 35 percent tax bracket, and it will use a
7 percent discount rate (rounded after-tax cost of debt) to analyze the refunding decision.
Should the old issue be refunded with new debt?
16–17. Solution:
Bowman Corporation
Outflows
1. Payment of call premium
2. Underwriting cost on new issue
Amortization of costs ($570,000/15) (.35)
Actual expenditure $570,000
Inflows
3. Cost savings in lower interest rates
Chapter 16: Long-Term Debt and Lease Financing
16-23
16–17. (Continued)
$ 195,000
× 9.108 PVIFA (n = 15, i = 7%) Appendix D
$1,776,060
4. Underwriting cost on old issue
Original amount $400,000
Amount written off over 5 years
at $20,000 per year 100,000
Summary
Outflows
1.
$1,040,000
3.
2.
448,864
4.
$1,488,864
PV of inflows
PV of outflows
Net present value
Refund the old issue (particularly if it is perceived that
interest rates will not go down even more).
Chapter 16: Long-Term Debt and Lease Financing
16-24
18. Refunding decision (LO3) The Robinson Corporation has $50 million of bonds
outstanding that were issued at a coupon rate of 11¾ percent seven years ago. Interest rates
have fallen to 10¾ 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. Brooks would 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
was 2.5 percent of the total bond value. The underwriting cost on the new 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 by one-half percent each year thereafter. (Consider the bond to be
seven 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. Should the
Robinson Corporation refund the old issue?
16–18. Solution:
Robinson Corporation
First compute the discount rate
Outflows
1. Payment on call provision (7th year = 9% call premium)
2. Underwriting cost on new issue
Actual expenditure $900,000
Chapter 16: Long-Term Debt and Lease Financing
16-25
16–18. (Continued)
Inflows
3. Cost savings in lower interest rates
Savings per year $500,000 × (1 – .35) = $325,000 Aftertax
4. Underwriting cost on old issue
Original amount (2.5% × $50,000,000) $1,250,000
Amount written off over last 7 years at
Present value of deferred future write off:
$50,000 × 10.059 502,950
16–18. (Continued)
Chapter 16: Long-Term Debt and Lease Financing
16-26
Summary
Outflows
Inflows
1.
$2,925,000
3.
$3,269,175
2.
723,967
4.
138,968
$3,648,967
$3,408,143
PV of inflows
$3,408,143
PV of outflows
3,648,967
Net present value
$ (240,824)
Based on the negative net present value, the Robinson
Corporation should not refund the issue. As time passes the
call premium will decline and if interest rates stay down or
decline further, the refunding decision could have a positive
net present value in the future.
19. Call premium (LO3) In problem 18, what would be the aftertax cost of the call premium
at the end of year 13 (in dollar value)?
16–19. Solution:
The Robinson Corporation (Continued)
Call premium (aftertax cost)
Year 1-5 not callable
Year 6……. 9.5% Year 10 ……. 7.5%
Chapter 16: Long-Term Debt and Lease Financing
16-27
OR
7 years of ½% deductions (7th through 13th year) = 3 ½%
9 ½% Call premiums
–3 1/2%
20. Capital lease or operating lease (LO4) The Deluxe Corporation has just signed a
120-month lease on an asset with a 15-year life. The minimum lease payments are $2,000
per month ($24,000 per year) and are to be discounted back to the present at a 7 percent
annual discount rate. The estimated fair value of the property is $175,000.
Should the lease be recorded as a capital lease or an operating lease?
Use criteria 3 and 4 on page 511 for a capital lease.
16–20. Solution:
The Deluxe Corporation
The lease is less than 75% of the estimated life of the leased
property.
However, the present value of the lease payments is greater than
90% of the fair value of the property.
Chapter 16: Long-Term Debt and Lease Financing
16-28
capital lease.
21. Balance sheet effect of leases (LO4) The Ellis Corporation has heavy lease commitments.
Prior to SFAS No. 13, it merely footnoted lease obligations in the balance sheet, which
appeared as follows:
In $ millions In $ millions
Current asserts ………………..…………
$ 50
Current liabilities …………………………
$ 10
Fixed asserts …………………..………
50
Long-term liabilities ……………….……
30
Total liabilities …………………………
$ 40
Stockholders’ equity ……………….……
60
Total assets …………………….…….
$100
Total liabilities and
stockholders’ equity …………………
$100
The footnotes stated that the company had $10 million in annual capital lease obligations
for the next 20 years.
a. Discount these annual lease obligations back to the present at a 6 percent discount rate
(round to the nearest million dollars).
b. Construct a revised balance sheet that includes lease obligations, as in Table 16–8
page 511.
c. Compute total debt to total assets on the original and revised balance sheets.
d. Compute total debt to equity on the original and revised balance sheets.
e. In an efficient capital market environment, should the consequences of SFAS No. 13,
as viewed in the answers to parts c and d, change stock prices and credit ratings?
f. Comment on management’s perception of market efficiency (the viewpoint of the
financial officer).
16–21. Solution:
The Ellis Corporation
Chapter 16: Long-Term Debt and Lease Financing
a. $10 million annual lease payments
16–21. (Continued)
b.
Current assets $50 million
Current liabilities $ 10 million
Fixed assets 50 million
Long-term liabilities 30 million
Leased property
under capital
lease 115 million
Total assets $215 million
Obligations under
capital lease 115 million
Total liabilities 155 million
Stockholders‘ equity 60 million
Total liabilities and
Stockholders’
equity $215 million
c.
Original Revised
Total debt $40 million $155 million
40% 72.1%
Total assets $100 million $215 million
= = =
d.
Original Revised
Total debt $40 million $155 million
66.7% 258.3%
Equity $60 million $60 million
= = =
Chapter 16: Long-Term Debt and Lease Financing
16-30
f. Management is concerned about whether the market is as
questionable.
22. Determining size of lease payment (LO4) The Hardaway Corporation plans to lease a
$900,000 asset to the O’Neil Corporation. The lease will be for 10 years.
a. If the Hardaway Corporation desires a 12 percent return on its investment, how much
should the lease payments be?
b. If the Hardaway Corporation is able to take a 10 percent deduction from the purchase
price of $900,000 and will pass the benefits along to the O’Neil Corporation in the
form of lower lease payments, (related to the Hardaway Corporation in the form of
lower initial net cost), how much should the revised lease payments be? Continue to
assume the Hardaway Corporation desires a 12 percent return on the 10-year lease.
16–22. Solution:
Hardaway Corporation
a. Determine 10–year annuity that will yield 12%.
A IFA
A = PV / PV (i = 12%, n = 10) Appendix D
$900,000
= $159,292
5.650 =