May 2001 course 6 #13(afternoon)

[LB]

Can someone give an answer to part (b). I don't know how they came up with that answer.

[monkey grass]

The sample answer doesn't do much in the way of explanation plus there are typo's.

Basically, should refinance if the after tax PV of savings on the lower coupon amount is greater than the after tax cost of calling the bond.

After Tax cost of Calling Bond = 6.5%+.325% = 6.825%
PV of Savings = 2.275% for 10 Years

After Tax return = 8.5% * .65 = 5.525%
PV of Savings = 2.275% * 10-year annuity at 5.525% = 22.68%

Since 22.68%>6.825% then refinance

In the solution, they solved for the after-tax return to make PV of Savings = After Tax cost of Calling the bond. Since 31%>5.525% then refinance.

Oh what a fun way to spend a Saturday night! :cry:

[zapped]

if anything like that is on this exam, i am in trouble

[LB]

The problem I had with this question is what to discount the annuity at because we are not given a yield only the coupon rate. How did you know to use the after tax rate of 8.5%?

[monkey grass]

I don't really think using the new coupon rate is quite right, but in the JAM manual for the Fall 1999 220 Exam- Problem #3, Carmody used the new coupon rate as the discount rate.

I think that to gauge the value to the company of reissuing, you would need the company's cost of capital. For example, if pre-tax the company thinks it can earn 10%, then the after-tax discount rate should be 10%*.6 = 6%. I don't think you should use the rate demanded by the market to loan money to the company.

Maybe that's why the sample solution backs into the rate that the after-tax rate would have to exceed to make reissuing not a good idea. After all, what company has an after-tax return of 31%!

[monkey grass]

if anything like that is on this exam, i am in trouble

Are you trying to pump up my confidence? :)