Short-term government securities

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Schumann Shoe Manufacturer is considering whether or not to refund a $70 million, 10% coupon, 30-year bond issue that was sold 8 years ago. It is amortizing $4.5 million of flotation costs on the 10% bonds over the issue's 30-year life. Schumann's investment bankers have indicated that the company could sell a new 22-year issue at an interest rate of 8 percent in today's market. Neither they nor Schumann's management anticipate that interest rates will fall below 6 percent any time soon, but there is a chance that interest rates will increase.

A call premium of 10 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Schumann's marginal federal-plus-state tax rate is 40 percent. The new bonds would be issued 1 month before the old bonds are called, with the proceeds being invested in short-term government securities returning 5 percent annually during the interim period.

Reference no: EM13746559

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