Question

Mullet Technologies is considering whether or not to refund a $75 million, 15% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $9 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 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 7% 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.

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

   $ _____

2. What factors would influence Mullet's decision to refund now rather than later? (100 words or 4 bullet points)

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Answer 1

Part A

Investment outlay required to refund the old issue:

Call Premium on Old Issue: $75 Mil. X 15% X (1-0.40) = -$6750000

New Floatation Cost = - $9,000,000

Tax Savings on the Old Floatation: $9.0 Mil. X 25 / 30 X 0.40 = +$3000000

Additional Interest on the Old Issue for 1 Month: $75 Mil. X 1/12 X 15% X (1-0.40) = -$562500

Interest Earned on Short Term Investment for 1 Month: $75 Mil. X 4% X 1/12 X (1-.40) = +$150000

Total of Initial Investment Outlay Required: -$4162500

Annual Tax Savings on Amortization of New Floatation Cost: $9 Mil. / 25 X 0.40 = +$144000

Annual Tax Benefit Lost on Amortization of Old Floatation Cost: $5 Mil. / 30 X .40 = - $120000

Net Annual Tax Savings on Amortization of New Floatation Cost = +$24000

PV of Net Annual Tax Savings on Amortization of New Floatation Cost = 24000* PVIFA(5.4%, 25) = $325100

Annual Interest Savings Due to Refunding:

Annual Interest on the Old Bond: $75 Mil. X 15% X (1-0.40) = +$6750000 Annually

Annual Interest on the New Bond: $75 Mil. X 9% X (1-0.40) = -$4050000 Annually

Net Annual After-Tax Interest Savings: =$2700000

Present value of Net Annual After-Tax Interest Savings = 2700000 * PVIFA(5.4%, 25) = +$36573750

NPV of the Refunding Decision = -4162500+325100+36573750 = $32736350

Part B

The estimates regarding interest rates in coming years should be considered. If interest rates are expected to fall down, waiting is preferred, however, if interest rates are expected to increase, immediate refunding is preferred. It is important to consider the reaction of investor towards calling off the old issue. If there are only small groups of investors, then calling off the old bonds may affect the future financing as this may disappoint the investors. The calling of bonds after a period of time, there are chances that bonds may be recalled by investors in case of decrease in interest rates.