1. When will the firm find it profitable to refund an issue? Give the example.

 It is important for investors to understand the process by which a firm decides whether to retire
an old bond and issue a new one. A simple and brief example will illustrate that process and
introduce the reader to the kinds of calculations a bondholder will make when trying to predict
whether a bond will be refunded. Suppose that a firm’s outstanding debt consists of $300 million
par value of a bond with a coupon of 10%, a maturity of 15 years, and a lapsed deferment period.
The firm can now issue a bond with a similar maturity for an interest rate of 7.8%. Assume that
the issuing expenses and legal fees amount to $2 million. The call price on the existing bond
issue is $105 per $100 par value. The firm must pay, adjusted for taxes, the sum of call premium
and expenses. To simplify the calculations, assume a 30% tax rate. This sum is then
$11,190,000. Such a transaction would save the firm a yearly sum of $4,620,000 in interest
(which equals the interest of $30 million on the existing bond less the $23.4 million on the new,
adjusted for taxes) for the next 15 years. The rate of return on a payment of $11,900,000 now in
exchange for a savings of $4,620,000 per year for 15 years is about 38%.This rate far exceeds
the firm’s after-tax cost of debt (now at 7.8% times 0.7, or 5.46%) and makes the refunding a
profitable economic transaction.

2. Unlike debt, payments made to preferred stockholders are treated as a distribution of

earnings. Explain.

 This means that they are not tax deductible to the corporation under the current tax code.
(Interest payments, on the other hand, are tax deductible.)

3. Although the after-tax cost of funds is higher if a corporation issues preferred stock rather than
borrowing, there is a factor that reduces the cost differential. Explain the statement and  what are
the implication of tax treatment of preferred stock dividends.

 A provision in the tax code exempts 70% of qualified dividends from federal income taxation if
the recipient is a qualified corporation. For example, if Corporation A owns the preferred stock
of Corporation B, for each $100 of dividends received by A, only $30 will be taxed at A’s
marginal tax rate. The purpose of this provision is to mitigate the effect of double taxation of
corporate earnings.
 There are two implications of this tax treatment of preferred stock dividends. First, the major
buyers of preferred stock are corporations seeking tax-advantaged investments. Second, the
cost of preferred stock issuance is lower than it would be in the absence of the tax provision
because the tax benefits are passed through to the issuer by the willingness of buyers to accept
a lower dividend rate.