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.

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.

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

Answer 1

Factors influencing the bond retirement decision

When bonds are issued, there is a chance that interest rates in the economy will change. If interest rates decrease below the coupon rate on the outstanding bonds, an issuer will pay off the bond and refinance its debt at the lower interest rate prevalent in the market. The proceeds from the new issue will be used to settle the interest and principal payment obligations of the existing bond. In effect, refunding is likely to be more common in a low interest-rate environment, as issuers with significant debt loads have an incentive to replace their maturing higher-cost bonds with cheaper debt.

Illustration

For example, an issuer that refunds a $100 million bond issue with a 10% coupon at maturity, and replaces it with a new $100 million issue (refunding bond issue) with a 6% coupon, will have savings of $4 million in interest expense per annum.

Refunding only occurs with bonds that are callable. Callable bonds are bonds which can be redeemed before they mature. Bondholders face call risk from holding these bonds – risk that the issuer will call the bonds if interest rates decline. To protect bondholders from having the bonds called too early, the bond indenture includes a call protection clause. The call protection is the period of time during which a bond cannot be called. During this lockout period, if interest rates drop low enough to warrant refinancing, the issuer will sell new bonds in the interim. The proceeds will be used to purchase Treasury securities which will be deposited in an escrow account. After the call protection expires, the Treasuries are sold an the funds in the escrow are used to redeem the outstanding high-interest bonds.

The new debt issues used in the process of refunding are referred to as refunding bonds. The outstanding bonds that are paid off using proceeds from the new issue are called refunded bonds. In order to retain the attraction of its debt issues to bond buyers, the issuer will generally ensure that the new issue has at least the same - if not a higher - degree of credit protection as the refunded bonds