Question

Mullet Technologies is considering whether or not to refund a $100 million, 13% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $9 million of flotation costs on the 13% 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 7% 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 6% 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.

Answer 1

Step 1: Computation of initial outlay.

Old issue call premium (after-tax) = (Issued amount * Call premium rate) * ( 1 - Tax rate)

= ($100,000,000 * 7.00%) * (1 - 40%) = $4,200,000

Flotation cost on old issue for the rest of the bond's life = Flotation cost * Remaining life / Total life of the bond

= $9,000,000 * 25 years / 30 years = $7,500,000

Tax savings on the flotation cost of old issue = $7,500,000 * 40% = $3,000,000

Flotation cost on the new bond = $6,000,000

After-tax interest on the old issue for 1-month = Old issue amount * Coupon rate * (1 - Tax rate) * 1 / 12

= $100,000,000 * 0.13 * (1 - 40%) * 1 / 12 = $650,000

After-tax interest on the new issue for 1 month = New issue amount * Government security rate of return * (1 - Tax rate) * 1 /12

= $100,000,000 * 0.06 * (1 - 40%) * 1 / 12 = $300,000

Initial outlay = Old issue call premium (after-tax) - Tax savings on the flotation cost + Flotation cost on the new bond + After-tax interest on the old issue for 1-month - After-tax interest on the new issue for 1 month

= $4,200,000 - $3,000,000 + $6,000,000 + $650,000 - $300,000 = $7,550,000

Step 2: Computation of annual cash inflow

Annual tax savings on flotation cost on the new issue = New issue flotation cost / Life of the new issue) * Tax rate

= ($6,000,000 / 25) * 40% = $96,000

Annual tax savings on flotation cost on the old issue = Old issue flotation cost / Life of the old issue) * Tax rate

= ($9,000,000 / 30) * 40% = $120,000

Effect of amortization = Annual tax savings on flotation cost on the new issue - Annual tax savings on flotation cost on the old issue

= $96,000 - $120,000 = -$24,000

Interest on old issue (after-tax) = Old issue amount * Coupon rate * (1 - Tax rate)

= $100,000,000 * 13% * (1 - 40%) = $7,800,000

Interest on new issue (after-tax) = New issue amount * Current market rate * (1 - Tax rate)

= $100,000,000 * 10% * (1 - 40%) = $6,000,000

Savings in interest amount = Interest on old issue (after-tax) - Interest on new issue (after-tax)

= $7,800,000 - $6,000,000 = $1,800,000

Annual cash inflow = Savings in interest amount + Effect of amortization

= $1,800,000 - $24,000 = $1,776,000

Step 3: Computation of net present value of bond refunding.

Discount rate = 10%

After-tax discount rate = 10% * (1 - 40%) = 6.00%

Present value of annual cash inflows = Annual cash inflows * [1 - (1 + After-tax discount rate)^{-Life of the issue}] / After-tax discount rate

= $1,776,000 * [1 - (1.06)^-25] / 0.06 = $22,703,240.54

Net Present Value (NPV) of bond refunding = Present value of annual cash inflows - initial outlay

= $22,703,240.54 - $7,550,000 = $15,153,240.54

The company should go with the bond refunding process because it's NPV is positive.