Question

Mullet Technologies is considering whether or not to refund a $100 million, 14% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 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 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 9% would be required to retire the old bonds, and flotation costs on the new issue would amount to $7 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

NPV of the refunding decision = NPV of the initial investment outlay + NPV of the flotation cost savings + NPV of interest savings

Given data:

Existing bond issue	100,000,000		New bond issue	100,000,000
Flotation cost	3,000,000		Flotation cost	7,000,000
Maturity (years)	30		Maturity (years)	25
Years since issue	5		New cost of debt	11.00%
Call premium (%)	9.00%		After-tax cost of debt	6.60%
Original coupon rate	14.00%		Tax rate	40%
			Short-term interest rate	5%

1). Initial investment outlay:

Formula	Investment outlay	Before-tax	After-tax
After-tax = before-tax*(1-tax rate)	Call premium on the old bond	(9,000,000)	(5,400,000)
It cannot be expensed immediately so after-tax = before-tax	Flotation cost of new issue	(7,000,000)	(7,000,000)
(Number of years remaining/total maturity)*flotation costs; After-tax = before-tax*tax rate	Tax saving on old flotation cost expense	2,500,000	1,000,000
Before-tax: Debt amount*interest rate*(1/12); After-tax = before-tax*(1-tax rate)	Extra interest paid on old issue	(1,166,667)	(700,000)
Interest earned on the new issue for 3 months: Debt amount*short-term interest rate*(1/12); After-tax = before-tax*(1-tax rate)	Interest earned on short-term investment	416,667	250,000
	Total after-tax investment		(11,850,000)

2). Annual flotation cost effect:

Formula	Annual flotation cost effect:	Before-tax	After-tax
Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual tax savings from new issue flotation costs	280,000	112,000
Before-tax :Flotation cost/Maturity; After-tax: before-tax*tax rate	Annual lost tax savings from old issue flotation costs	(100,000)	(40,000)
	Net flotation cost savings		72,000

3). Annual interest savings:

	Annual interest savings due to refunding:	Before-tax	After-tax
Debt amount*cost of debt; After-tax: before-tax*(1-Tax rate)	Interest paid on new bond	(11,000,000)	(6,600,000)
Debt amount*coupon rate; After-tax: before-tax*(1-Tax rate)	Interest paid on old bond	14,000,000	8,400,000
	Net interest savings		1,800,000

4). NPV of annual flotation cost savings:

	NPV of annual flotation cost savings:
(N)	New bond maturity (years)	25
(I)	After-tax cost of new debt	6.60%
(PMT)	Annual flotation cost savings	72,000.00
Using PV function	NPV of annual flotation cost savings	870,180.57

5). NPV of annual interest savings:

	NPV of annual interest savings:
(N)	New bond maturity (years)	25
(I)	After-tax cost of new debt	6.6%
(PMT)	Annual net interest savings	1,800,000
Using PV function	NPV of annual interest savings	21,754,514.37

6). Net NPV of the bond refunding decision:

NPV of bond refunding:
Initial investment outlay	(11,850,000)
NPV of flotation cost savings	870,180.57
NPV of interest savings	21,754,514.37
NPV of bond refunding decision	10,774,694.95

Bond's refunding NPV = 10,774,694.95  

If interest rates are set to rise then Mullet can decide to refund now rather than later as it will be cheaper to issue debt when interest rates are low.