Question

Mullet Technologies is considering whether or not to refund a $50 million, 12% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $9 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 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
Initial investment outlay to refund old issue:
Call premium on old issue	50,000,000*12%	6,000,000
After-tax call premium	6000000*(1-40%)	3,600,000
New flotation cost		6,000,000
Old flotation costs already expensed	(9,000,000/30)*(30-25) =	1,500,000
Remaining flotation costs to expense	9000000-1500000	7,500,000
Tax savings from old flotation costs	7500000*40%	3,000,000
Additional interest on old issue after tax	50,000,000*12%*(1/12)*(1-40%)	300,000
Interest earned on investment in T-bonds after tax	(50,000,000*7%*1/12)*(1-40%)	175,000
Total investment outlay	3600000+6000000+3000000+300000+175000	13,075,000
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation	6,000,000*40%/25	96,000
Tax savings lost on old flotation	9,000,000*40%/30	120,000
Total amortization tax effects		(24,000)
Annual interest savings due to refunding:
Annual after tax interest on old bond	50,000,000*12%*(1-40%)	3,600,000
Annual after tax interest on new bond	50,000,000*9%*(1-40%)	2,700,000
Net after tax interest savings		900,000
Annual cash flows	-24000+900000	876,000
NPV of bond refunding decision	-13075000-876000*(((1-1.07^-25))/0.07)	23,283,539
b
It should refund now as interest rate will not fall below 9% it may increase in nearby future.