Question

Refunding Analysis

Mullet Technologies is considering whether or not to refund a $250 million, 13% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $9 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 9% in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 9% any time soon, but there is a chance that rates will increase.

A call premium of 12% would be required to retire the old bonds, and flotation costs on the new issue would amount to $6 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 7% 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

A. Bond refunding's NPV = present value of annual cash flows - Total cash outflows for refund

If NPV is positive then refunding can be done.

Annual cash flows = Total amortization tax effects + Net after tax interest savings

the bond refunding's NPV is $47,891,813.07.

B. Interest rates and current price of the old bond factors would influence Mullet's decision to refund now rather than later. If current interest rate is lower than bond's coupon rate and current price of the bond is lower than its Par value than bond can be refunded now rather than later.

If market interest rate is lower than coupon paid by bond issuer than it make sense to refund the old bond and issue new bonds at lower interest rate provided NPV of refunding is positive.