Ten years ago, DEWA, an electricity and water authority, issued $20 million worth of municipal bonds that carried a coupon rate of 6% per year, payable semiannually. The bonds had a maturity date of 25 years. Due to a worldwide recession, interest rates dropped significantly enough for the utility to consider paying off the bonds early at a 10% penalty to the face value. DEWA would then reissue the bonds at the same face value (i.e., $20 million) for the remaining 15 years, but at a lower coupon rate of 2% per year, payable semiannually. What would be the semiannual rate of return to DEWA, if it proceeds with this plan?
What will be an ideal response?
The utility would pay a penalty of $2,000,000 in return for saving 4% per year, payable Semiannually on $20 million for 15 years.
0 = -2,000,000 + [20,000,000(0.04)/2](P/A,i*,30)
Solve for i by trial and error or spreadsheet
i* = 19.9% per six months (spreadsheet)
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