Question

Problem 18-07
Refunding Analysis

Mullet Technologies is considering whether or not to refund a $175 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 4% 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.

Please show work and calculations so I can try and understand :)

Answer 1

The initial investment outlay to refund the old issue = after-tax call premium on old issue + new flotation cost - tax savings from old flotation costs + additional after-tax interest on old issue - interest earned on investments in interim period

after-tax call premium on old issue = par value of old issue * call premium * (1 - tax rate)

tax savings from old flotation costs = (old flotation costs - old flotation costs already expensed) * tax rate

additional interest on old issue after tax = interest paid on old bonds during interim period

interest earned on investments in interim period = interest earned on proceeds of new bonds during interim period

Annual incremental cash flows = After-tax interest savings + Flotation cost amortization tax effects

After-tax interest savings = after-tax interest on new bonds - after-tax interest on old bonds

Flotation cost amortization tax effects = annual tax savings on new flotation costs - tax savings lost on old flotation costs

NPV of bond refunding = present value of annual incremental cash flows - initial investment outlay

In calculating the present value of annual incremental cash flows, the discount rate used is the after-tax rate of the new issue.

NPV of bond refunding = $28,823,271.35