Question

Refunding Analysis Mullet Technologies is considering whether or not to refund a $250 million, 15% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 million of flotation costs on the 15% 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 8% would be required to retire the old bonds, and flotation costs on the new issue would amount to $7 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 4% 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.

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

Answer 1

Given data:
Existing bond issue	250,000,000		New bond issue	250,000,000
Flotation cost	3,000,000		Flotation cost	7,000,000
Maturity of the original debt (years)	30		Maturity (years)	25
Years since issue	5		New cost of debt	11%
Call premium (%)	8%		After-tax cost of debt	6.6%
Original coupon rate	15%		Tax rate	40%
			Short-term interest rate	4%

Calculations:

Step 1:

	Cash flow schedule:
Formula	After-tax investment	Before-tax	After-tax
After-tax = before-tax*(1-tax rate)	Call premium on the old bond	(20,000,000)	(12,000,000)
It cannot be expensed immediately so after-tax = before-tax	Flotation cost of new issue	(7,000,000)	(7,000,000)
(Number of years remaining/total maturity)*flotation costs; After-tax = before-tax*tax rate	Tax saving on old flotation cost expense	2,500,000	1,000,000
Before-tax: Debt amount*interest rate*(1/12); After-tax = before-tax*(1-tax rate)	Extra interest paid on old issue	(3,125,000)	(1,875,000)
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	833,333	500,000
	Total after-tax investment		(19,375,000)
	Annual flotation cost effect:	Before-tax	After-tax
Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual tax savings from new issue flotation costs	280,000	112,000
Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual lost tax savings from old issue flotation costs	(100,000)	(40,000)
	Net flotation cost savings		72,000
	Annual interest savings due to refunding:	Before-tax	After-tax
Before-tax: Debt amount*before-tax cost of debt; After-tax: before-tax interest*(1-tax rate)	Interest paid on new bond	(27,500,000)	(16,500,000)
Before-tax: Debt amount*coupon rate; After-tax: before-tax intereat*(1-tax rate)	Interest paid on old bond	37,500,000	22,500,000
	Net interest savings		6,000,000

Step 2:

	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	72,000
(NPV calculated using PV function)	NPV of annual flotation cost savings	870,180.57
	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	6,000,000
(NPV calculated using PV function)	NPV of annual interest savings	72,515,047.90
	NPV of bond refunding:
	Initial outlay (IO)	(19,375,000.00)
	NPV of flotation cost savings (FCS)	870,180.57
	NPV of interest savings (IS)	72,515,047.90
IO + FCS + IS	NPV of the refunding decision	54,010,228.48

a). NPV of the refunding decision = 54,010,228.48

b). If there is a strong possibility that interest rates are going to rise in the future then Mullet Technologies would prefer to refund now rather than wait and do it later as refunding would not be useful when interest rates are high.