Stern Co., a year ago, issued $100 million of 11 year bonds with 9% coupon, payable annually. The first coupon payment has just been paid. Bonds are callable at 103beginning today. Costs of flotation on that issue were $1 million. Stern Co., has a 34% marginal tax rate. As the interests fell, Stern Co., is considering calling inthe bonds and refinancing at the current rates. It has two, 10-year financing alternatives.
a) A $100 million public issue of 8% annual coupon bonds. Flotation costs are $1Million. b) A 8% $100 million private placement with semi-annual coupons. There is font-end placement fee of $250,000.
Call premiums and interest payments are tax deductible. However, front-end fees and flotation costs must be capitalized and amortized over the life of thebond.
1. Calculate the effective cost of raising funds from the public bond issue. Use the IRR procedure for all your calculations.
2. Calculate the effective cost of raising funds from the private placement of debt.
3. If Stern Co., does call in the bonds, which of the two refinancing types is preferable?
4. what is the effective after-tax cost of leaving the current bonds in place? what would be the after-tax all-in cost of refinancing that would make Stern Co.,indifferent between calling the bonds and leaving them in place? 5. Should Stern Co., call in the bonds at all?