In: Finance
Problem 18-07
Refunding Analysis
Mullet Technologies is considering whether or not to refund a $200 million, 14% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $6 million of flotation costs on the 14% 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 10% 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 5% 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.
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What factors would influence Mullet's decision to refund now rather than later?
a. 1. Initial outlay | Mlns. | Mlns. |
After-tax call premium on old bonds(200*14%*(1-40%)) | -16.8 | |
Flotation cost on the new bonds | -5 | |
Immediate Tax savings on unamortised flotation cost of old bonds((6-1)*40%) | 2 | |
1-mth extra after-tax int. on old issue(200*14%/12*(1-40%)) | -1.4 | |
1 month after-tax int. on new issue(200*5%/12*(1-40%) | 0.5 | |
Total after-tax initial investment | -20.7 | |
2.Annual flotation tax effects | ||
Tax savings annuity on the new issue for 25 yrs.(5/25*40%) | 0.08 | |
Tax savings annuity lost on old issue(6/30*40%) | -0.08 | |
Net annual tax savings lost | 0 | |
PV F,i=6.0%, n=25 yrs.----------10%*(1-40%) | 12.78336 | |
PV of annual flotation tax effects lost | 0 | |
3. Annual interest savings | ||
After-tax interest cost savings(200*(14%-10%)*(1-40%)= | 4.8 | |
PV F,i=6.0%, n=25 yrs. | 12.78336 | |
PV of annual after-tax interest savings | 61.36013 | |
NPV of refunding (1+2+3) | 40.66013 | |
b..Mullet's decision to refund now rather than later, will be influenced by the given fact that there are chances for the interest rates to increase--in which case there may not be any interest cost savings--- as shown in point 3. above |