Question

Problem 18-07
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 $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 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 7% would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 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

1. Calculation of NPV:

Particulars	Amount
Call premiumon old issue	$97,50,000
New flotation cost	$60,00,000
Tax savings on old flotation	$20,00,000
Additional interest on old issue	$8,12,500
Interest earned on investinent:	$2,50,000
Total investment outlay:	$1,43,12,500
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation	$96,000
Tax benefits lost on old flotation:	$80,000
Amortization tax effects	$16,000
Annu al Interest Savings Due to Refunding:
Annual interest on old bond:	$97,50,000
Annual interest on new bond:	$82,50,000
Net interest savings	$15,00,000
Annual cash flows:	$15,16,000
NPV of refunding decision	$93,70,573.19

Excel working

Particulars	Amount
Call premiumon old issue	=(125000000* 13%)*(l-40%)
New flotation cost	6000000
Tax savings on old flotation	=(6000000-(6000000*(5/30)))*40%
Additional interest on old issue	=(125000000*(1/ 12)*13%*(l-40%))
Interest earned on investinent:	=(125000000*(1/ 12)*4%*(l-40%))
Total investment outlay:	=B2+B3-B4+B5-B6 (Tottal of above)
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation	=(6000000*40%)/25
Tax benefits lost on old flotation:	=(6000000*40%)/30
Amortization tax effects	=B9-B10
Annu al Interest Savings Due to Refunding:
Annual interest on old bond:	=(125000000* 13%)*(l-40%)
Annual interest on new bond:	=125000000* 11%*(l-40%)
Net interest savings	=B13-B14
Annual cash flows:	=B15+B11
NPV of refunding decision	=PV(4% 25 -B16 O)-B7