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eBook Problem 18-07 Refunding Analysis Mullet Technologies is considering whether or not to refund a $100...

eBook

Problem 18-07
Refunding Analysis

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.

  1. Conduct a complete bond refunding analysis. What is the bond refunding's NPV? Do not round intermediate calculations. Round your answer to the nearest cent.

    $  

  2. What factors would influence Mullet's decision to refund now rather than later?

Solutions

Expert Solution

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


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