Question

Decision Making

LO.5 Mila purchased a Zaffre Corporation $100,000 bond 10 years ago for its face value. The bond pays 5% interest annually. In a “Type E” reorganization, Zaffre exchanges Mila’s bond with 10 years remaining for a 15-year bond also having a face value of $100,000 but paying 4.5% annual interest.

Mila earns a 3% after-tax rate of return, and she is in the 25% state and Federal income tax bracket for all years. Determine whether this is an equitable exchange for Mila. Prepare your solution using spreadsheet software such as Microsoft Excel. (Hint: Use Present Value of a $1, Present Value of an Ordinary Annuity of $1, Future Value of a $1, Future Value of an Ordinary Annuity of $1)

Answer 1

Please find below table useful to compute desired results: -

A i Face value of 10years bonds 100000 2 Interest on bonds 1=5/100 3 Face value of 15years bonds 100000 4 Interest on bonds =4.5/100 5 After tax rate of return =3/100 6 State and Federal income tax =25/100 7 Cost of Debt 8 Mila's Purchase =C1*C2*(1-C6)/C1 =C1*B8 9 Zaffre's Exchange =C3*C4*(1-C6)/C3 =C3*B9 10 Mila's Earning after tax =C5 =C3%B10 11 PVAF =((1+C5)^10-1)/(C5*(1+C5) 10) 12 PVIF =(1+C5)(-10) 13 Present value of bonds =C3*C12+C9*c11

End results would be as follows: -

3% А BC 1 Face value of 10years bonds 100,000 2 Interest on bonds 5% 3 Face value of 15years bonds 100,000 4 Interest on bonds 4.50% 5 After tax rate of return 6 State and Federal income tax 25% 7 Cost of Debt 8 Mila's Purchase 3.75% 3,750 9 Zaffre's Exchange 3.38% 3,375 10 Mila's Earning after tax 3% 3.000 11 PVAF 8.5302 12 PVIF 0.7441 13 Present value of bonds 103,199 The exchange is equitable for Mila because in case of exchange the cost of debt is lower and PV is more than the Face Value 14