Question

Mullet Technologies is considering whether or not to refund a $200 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 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 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 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. $ What factors would influence Mullet's decision to refund now rather than later?

Answer 1

1. Initial outlay	Mlns.	Mlns.
After-tax call premium on old bonds(200*14%*(1-40%))	-16.8
Flotation cost on the new bonds	-3
Tax savings on unamortised flotation cost of old bonds((9-1.5)*40%)	3
1-mth extra after-tax int. on old issue(200*12%/12*(1-40%))	-1.2
1 month after-tax int. on new issue(200*5%/12*(1-40%)	0.5
Total after-tax initial investment		-17.5
2.Annual flotation tax effects
Tax savings annuity on the new issue for 25 yrs.(3/25*40%)	0.048
Tax savings annuity lost on old issue(9/30*40%)	-0.12
Net annual tax savings lost	-0.072
PV F,i=6.6%, n=25 yrs.----------11%*(1-40%)	12.08584
PV of annual flotation tax effects lost		-0.87018
3. Annual interest savings
After-tax interest cost savings(200*(12%-11%)*(1-40%)=	1.2
PV F,i=6.6%, n=25 yrs.	12.08584
PV of annual after-tax interest savings		14.50301
NPV of refunding		-3.86717
Given that there are chances for the interest rates to increase,refunding might have to be done , at an even-more cash-loss, as there may not be any interest cost savings also.