Question

eBook Problem 18-07 Refunding Analysis Mullet Technologies is considering whether or not to refund a $250 million, 12% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $6 million of flotation costs on the 12% 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 15% 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 4% annually during the interim period. 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. $   What factors would influence Mullet's decision to refund now rather than later?

Answer 1

What is the bond refunding's NPV?

1. Calculation of initial outlay:-

   		$(million)
   a.     Face value	250
   Add:-Call premium (15%)	37.5
   Cost of calling old bonds		287.5
   b. Overlapping Interest cost for one month   (Note-1)
   Before Tax (0.12*1/12*250)	2.5
   Less Tax 40%	1	1.5
   c.    Interest from Govt Securities (250*4%*1/12)		0.83
   d.   Gross proceed of new issue	250
   Less: Issue costs	4
   Net proceeds of new issue		246
   e. Tax savings on call premium and unamortized cost 0.40 (37.5 + 4)		16.6

Therefore, Initial outlay = $287.5 million + $ 1.5 million – 0.83 million – $246 million – $16.6 million = $25.57 million

2. Calculation of net present value of refunding the bond:-

		$(million)
Saving in annual interest expenses
[250 x (0.12 – 0.10)]	5
Less:- Tax saving on interest and amortization
0.40 x [5 + (6-4)/25]	2.03
Annual net cash saving		2.97
PVIFA (6%, 25 years) (Note-2)		12.783
Present value of net annual cash saving		$36.97 million
Less:- Initial outlay		$25.57 million
Net present value of refunding the bond		$12.40 million

Decision: The bonds should be refunded

Note : 1. Since, the new bond will issued a month before the refunding of the old bond, the company would have to pay the overlapping interest for the Old bond as well for one month.

2. The annuity factor would be the after tax cost of debt of new bond i.e. 10 – (10*0.40) = 6%

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

The factors influencing the Mullets decision to refund now are as follows:

1. Lower interest cost, the new bond carries a coupon rate of 10% lower than the old bond of 12%, which would significantly reduce the interest cost.
2. Expected Stagnation in the Interest Rate, the bankers of the Mullet expects that the interest rate is not expected to go down below 10% in near future.