Question

Refunding Analysis Mullet Technologies is considering whether or not to refund a $150 million, 13% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 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 9% in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 9% any time soon, but there is a chance that rates will increase.

A call premium of 8% 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.

a. 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.

b. What factors would influence Mullet's decision to refund now rather than later?

Answer 1

a]

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 = $35,940,299.88

NPV of bond refunding = $35,940,299.88

b]

Neither the investment banks nor Mullet's management anticipate that interest rates will fall below 9% any time soon, but there is a chance that rates will increase.

Hence, Mullet would be keen to refund now, and take advantage of the low interest rates (which are not anticipated to fall any further), rather than refund later when there is a chance that interest rates will be higher.

150,000,000 13.00Z 30 1 Current bond issue information 2 Par Talee 3 coupon rate original maturity remaining Baturity 6 original flotation costs 7 Call premier Tai rate $ 3.000.000 8.002 40.002 9.002 11 Her issue information 12 Coupon rate 13 maturity 14 flotation costs 15 after-tax rate of net issue $ 7.000.000 5.402 16 17 18 Tine between issues (nonths) rate on surplus funds (annual) 5.002 20 Initial intestacat outlay to refund old issue: 21 Call presies om old issue = 22 After-tar call prein = 23 Her flotation cost = 24 Old flotation costs already ciptased = 25 Remaining flotation costs to expense = 26 Tar sarings from old flotation costs = 27 Additional interest on old issue after tar = 28 laterest earned on icreateget is T-bonds after tar = 29 Total intestacat outlay = 12,000,000.00 7,200.000.00 7.000.000.00 500.000.00 2,500,000.00 1,000,000.00 You get to tipease the remaining flotation costs 975,000.00 Tlis is interest paid on the old bond issue betreel then the act bonds are issued and the old bonds art retired 375,000.00 This is interest earned on the proceeds from the mer bonds before they are used to pay off the old bonds. $ 13,800,000.00 31 Annual Flotation Cost Tax Effects: 32 Aareal tar savings on her flotation = 33 Tar savings lost on old flotation = Total asortization tar effects = 112.000.00 40,000.00 72,000.00 35 36 Annual interest sarings due to refunding: 37 Ameal after tar interest on old bond = 38 Ameal after tar interest on see bond = 39 Het after tar interest savings = $ 1 $ 11,700,000.00 8.100.000.00 3.600.000.00 40 3,672,000.00 41 Annual cask flors = 42 43 HPY of refunding decision = 35,940.299.88