Question

Refunding Analysis Mullet Technologies is considering whether or not to refund a $125 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 11% in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 11% any time soon, but there is a chance that rates will increase. A call premium of 9% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 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 6% annually during the interim period.

A. 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.

I need an answer. There was not an answer given when i posted the question yesterday just a bunch of different numbers. Thanks.

Answer 1

Given data:
Existing bond issue	125,000,000		New bond issue	125,000,000
Flotation cost	6,000,000		Flotation cost	3,000,000
Maturity of the original debt (years)	30		Maturity (years)	25
Years since issue	5		New cost of debt	11%
Call premium (%)	9%		After-tax cost of debt	6.6%
Original coupon rate	13%		Tax rate	40%
			Short-term interest rate	6%

Step 1) - Initial cash flow schedule:

Column	Formula		Before-tax	After-tax
A	Call premium = existing bond issue*call premium; After-tax = before-tax*(1-tax rate)	Call premium on the old bond	(11,250,000)	(6,750,000)
B	It cannot be expensed immediately so after-tax = before-tax	Flotation cost of new issue	(3,000,000)	(3,000,000)
C	(Number of years remaining/total maturity)*flotation costs; After-tax = before-tax*tax rate	Tax saving on old flotation cost expense	5,000,000	2,000,000
D	Before-tax: Debt amount*interest rate*(1/12); After-tax = before-tax*(1-tax rate)	Extra interest paid on old issue	(1,354,167)	(812,500)
E	Interest earned on the new issue for 1 month: Debt amount*short-term interest rate*(1/12); After-tax = before-tax*(1-tax rate)	Interest earned on short-term investment	625,000	375,000
	A+B+C+D+E	Total after-tax investment		(8,187,500)

Step 2) - Cash flows from annual flotation cost:

Column		Annual flotation cost effect:	Before-tax	After-tax
A	Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual tax savings from new issue flotation costs	120,000.00	48,000.00
B	Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual lost tax savings from old issue flotation costs	(200,000)	(80,000)
	A+B	Net flotation cost savings		(32,000.00)

Step 3) - Cash flows from annual interest savings due to the proposed refunding:

Column		Annual interest savings due to refunding:	Before-tax	After-tax
A	Before-tax: Debt amount*before-tax cost of debt; After-tax: before-tax interest*(1-tax rate)	Interest paid on new bond	(13,750,000)	(8,250,000)
B	Before-tax: Debt amount*coupon rate; After-tax: before-tax interest*(1-tax rate)	Interest paid on old bond	16,250,000	9,750,000
	A+B	Net interest savings		1,500,000

Step 4) - NPV calculation for savings from annual flotation costs:

	NPV of annual flotation cost savings:
(N)	New bond maturity (years)	25
(I)	After-tax cost of new debt	6.6%
(PMT)	Annual flotation cost savings	(32,000)
(calculated using PV function)	NPV of annual flotation cost savings	(386,746.92)

Step 5) - NPV calculation for annual interest savings:

	NPV of annual interest savings:
(N)	New bond maturity (years)	25
(I)	After-tax cost of new debt	6.6%
(PMT)	Annual net interest savings	1,500,000
(NPV calculated using PV function)	NPV of annual interest savings	18,128,761.98

Step 6) - NPV calculation for the refunding decision:

Column	NPV of bond refunding:
A	Initial outlay	(8,187,500.00)
B	NPV of flotation cost savings	(386,746.92)
C	NPV of interest savings	18,128,761.98
A+B+C	NPV for the bond refunding decision	9,554,515.05

Answer: NPV for the bond refunding decision is $9,554,515.05