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Problem 18-07 Refunding Analysis Mullet Technologies is considering whether or not to refund a $200 million,...

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.

  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?

Solutions

Expert Solution

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

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