Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Dove Construction Company Ltd made a Sh.100 million bondage 5 years ago when interest rates were substantially high. The interest rates have now fallen and the firm wishes to retire this old debt and replace it with a new and cheaper one. Given here below are the details about the two bond issues:
Old Bonds: The outstanding bonds have a nominal value of Sh.1,000 and 24% coupon interest rate. They were issued 5 years ago with a 15-year maturity. They were initially sold a their nominal value of Sh.1,000 and the firm incurred Sh.390,000 in floatation costs. They are callable at Sh.1,120.
New Bonds: The new bonds would have a Sh.1,000 nominal value and a 20% coupon interest rate. They would have a 10-year maturity and could be sold at their par value. The issuance cost of the new bonds would be Sh.525,000.
Assume the firm does not expect to have any overlapping interest and is in the 35% tax bracket.

a) Calculate the after-tax cash inflows expected from the unamortized portion of the old bond‟s
issuance cost.

b) Calculate the annual after-tax cash inflows from the issuance of the new bonds assuming the 10-year amortization.

c) Calculate the after-tax cash outflow from the call premium required to retire the old bonds.

d) Determine the incremental initial cash outlay required to issue the new bonds.

e) Calculate the annual cash-flow savings, if any, expected from the bond refunding.

f) If the firm has a 14% after-tax cost of debt, would you recommend the proposed refunding and
reissue? Explain.

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