Question

Mullet Technologies is considering whether or not to refund a $75 million, 12% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $5 millions 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 10% in today’s market. A call premium of 12% would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Mullet’s marginal tax rate is 40%.

a. What is the cash outlay at the time of the refunding?

b. What is the net change in the annual flotation cost tax savings?

c. What is the after-tax annual interest savings?

d. What is the bond refunding’s NPV? What is the decision?

Answer 1

a)

In order to calculate the cash outlay for refunding, let us calculate the following step by step

Firstly, let us calculate the call premium on old issue:

Given 12% coupon rate, $75 million of refunding, 40% tax rate

Call premium = $75,000,000 X 0.12 X (1-0.4) = -$5,400,000

New Floatation Cost given as                                          - $5,000,000

Tax savings on the old floatation

Given 25 year issue and 30 year issue life

$5,000,000 X (25 / 30) X 0.4 =                                      +$1,666,667

Additional Interest on the old Issue for 1 Month

$75,000,000 X 1/12 X 0.012 X (1-.40) =                        -$450,000

Interest earned on short term investment for 1 month

$75,000,000 X 0.06 X 1/12 X (1-.40) =                         +$225,000

Total of cash outlay is

-$5,400,000 -$5,000,000 +$1,666,667 -$450,000 +$225,000

= -$8,958,333

b)

annual flotation cost tax savings of new issue = $5,000,000 / 25 X 0.40 = $80,000

annual flotation cost tax savings of old issue = $5,000,000 / 30 X 0.40 = $66,667

Net change in annual flotation cost tax savings = $80,000- $66,667 = $13,333

c)

Annual interest on old issue = $75,000,000 X 12% X (1-.40) = +$5,400,000

Annual interest on new issue = $75,000,000 X 10% X (1-.40) = $4,500,000

Annual Interest Savings = $5,400,000 - $4,500,000 =$900,000

d)

NPV= PV of total savings – cash outlay

Total savings = $13,333 + $900,000 = $913,333

Cash outlay = $8,958,333

Here discount rate = 10% (1-.40) = 6% over 25 years.

NPV= $913,333 X PVIFA (6%,25years)- $8,958,333

NPV = $913,333 X 12.7834- $8,958,333

NPV = $2,717,168.072

As NPV is positive, it is better that Mullet Technologies can issue new bonds by refunding of old bonds