Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations ⎯assume that the firm's tax rate is zero. The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?

11.6%

Explanation:

the total cost of calling the bonds = ($50 + $10) x ($5,000,000 / $1,000) = $300,000

the bonds' coupon payment = $5,000,000 x 12% = $600,000

the company should call the bonds only if it is profitable, and the savings are equal or higher than the costs

cost of calling the bonds ≤ number of years x (coupon - rate) x total bonds

$300,000 = 15 x [$600,000 - (rate x $5,000,000)]

$300,000 / 15 = $600,000 - (rate x $5,000,000)

$20,000 = $600,000 - (rate x $5,000,000)

rate x $5,000,000 = $580,000

rate = $580,000 / $5,000,000 = 0.116 = 11.6%

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