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Problem 18-07 Mullet Technologies is considering whether or not to refund a $100 million, 13% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $6 million of flotation costs on the 13% bonds over the issue's 30-year life. Mullet's investment banks have indicated that the company could sell a new 25-year issue at an interest rate of 10% in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 10% any time soon, but there is a chance that rates will increase. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $4 million. Mullet's marginal federal-plus-state tax rate is 40%. 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% annually during the interim period.
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a) NPV of Bond Refunding Decision
Step 1 : Calculation of Initial Investment (Y) or After Tax Refunding investment expenditure
PARTICULARS |
AMOUNT |
Refund of Old Bonds ($150,000,000 * 1.10) |
165,000,000 |
Less : Net Proceeds From New Bond Issue ( $ 150,000,000 – 4,000,000) |
(146,000,000) |
Less : Tax Shield on Call Premium ( 40% OF 15,000,00) |
(6,000,000) |
Less : Tax shield on Unamortized Flotation Cost ( 6,000,00030*25)*40% |
(2,000,000) |
Add : Post Tax Coupon Amount of Old Bonds For 1 month [($150,000,000 * 15% * 1/12) * 0.60] |
1,125,000 |
Less : Post Tax Interest Amount on New Bonds for One Month [($146,000,000 * 5% * 1/12) * 0.60] |
(365,000) |
Initial Investment |
11760000 |
Step 2 : Calculation of Annual Post Tax Savings (X)
Particulars |
Old Bond |
New Bond |
Post Tax Coupon Amount 15%*150,000,000*0.6 10%*150,000,000*0.6 |
13500000 |
9000000 |
Less : Annual Tax Shield On Flotation Cost (6000000/30)*0.40 (4000000/25) * 0.40 |
(80000) |
(64000) |
Annual Post Tax Savings |
13,420,000 |
8,936,000 |
Therefore Annual Savings Post Tax (X) =13420000 -8936000 = $ 4,484,000
Step 3 : NPV
Important Assumption : The firms Cost of Debt is not Provided in the Question to calculate NPV we have assumed that the firms cost of debt is 6 % (10*0.60) i.e after tax cost of new debentures. If different cost of debt is given student shall replace cost of debt in step 3.
NPV = X * PVAF (6%,25) – Y
= ($4484000*12.7833) - $ 11760000
= $ 57269435 - $ 11760000
= $ 45509435
Since NPV is Positive bond Refunding Decision is Viable
b) Factors that would influence Mullets Decision to refund now
i) There is a chance that interest rates will increase in future so the best rate available is 10% as the rates of bond will not fall below 10%
ii) Flotation cost of bonds is also low as compared to flotation cost of old bonds
iii) Interest rate on new bonds are lower than old bonds which will result in less cash outflow