Warner Motor Oil Company
Case 25
Bond Refunding
Purpose: The case gives the student a clear insight into the refunding process. The importance of the call
privilege is emphasized. Clearly, a refunding would not be feasible if the old issue had to be reacquired at
market value. The case also provides an example of when a positive net present value may not be
sufficient justification for taking action if the NPV is likely to be even larger in the future. There is also
an optional question which allows the student to compare accounting implications with cash flow and net
present value considerations. Normally, a refunding decision hurts accounting profits in the first year,
and increases them in all subsequent years.
Relation to Text: The case draws primarily on material from Chapter 16. However, the student should be
familiar with computing bond prices as presented in Chapter 10.
Complexity: The case is moderately complex. It should require 1 – 1½ hours.
Solutions
1. Price of Previously Issued Bonds
Present value of interest payments
PVA = A x PVIFA (n = 30, i = 5%) Appendix D
1.
$1,680,000
2.
$2,366,986
PV of inflows ……………….
PV of outflows ……………..
Net of present value ………
11.5% (interest on old bond) x $30,000,000
=
$3,450,000/year
10.4% (interest on new bond) x $30,000,000
=
Savings per year
=
$ 330,000
Savings per year
=
$ 231,000 aftertax
PV of A/T savings in interest rates
4. Underwriting cost on old issue
Original amount …………………………………………………………………………………………………..
$400,000
Amount written off over 5 years at $20,000 per year ………………………………………………..
–100,000
Unamortized old underwriting cost …………………………………………………………………………
$300,000
Present value of deferred future write-off
$20,000 x 9.108 (n = 15, i = 7%) ……………………………………………………………………………
–182,160
Immediate gain in old underwriting cost write-off ……………………………………………………
$117,840
Tax rate ………………………………………………………………………………………………………………
x .30
Aftertax value of immediate gain in old underwriting cost write-off …………………………..
$ 35,352
We now plug this figure into our summary of outflows and inflows. All prior values are the same.
Summary
Outflows
Inflows
1.
$1,680,000
3.
$2,103,948
2.
686,986
4.
35,352
$2,366,986
$2,139,300
PV of inflows ………………
$2,139,300
PV of outflows …………….
–2,366,986
Net of present value ……..
$ (227,686)
The potential refunding has a negative net present value and should not be undertaken.