Question

Mullet Technologies is considering whether or not to refund a $50 million, 14% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $6 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 $5 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 7% annually during the interim period.

A.) Conduct a complete bond refunding analysis. What is the bond refunding's NPV?

Answer 1

The complete bond refunding analysiswill have three components.

1. Figure out total investment outlay
2. Figure out annual cash flows:
   1. Figure out total amortization tax effects
   2. Figure out net post tax interest savings
3. Use total investment outlay andannual cash flows to calculate NPV of bond refunding

Part 1: Figure out the total initialinvestment outlay to refund the old issue

• Pre tax call premium to be paid onrefund = Call premium rate x face value of old issue = 9% x500,00,000 = 45,00,000
• Post tax call premium to be paid =Pre tax call premium to be paid x (1 - tax rate) = 45,00,000 x (1- 40%) = 27,00,000
• Floatation cost on new issue =50,00,000
• Balance old floatation cost = (Oldfloatation cost / Life of the old bond) x balance life = 60,00,000/ 30 x (30 - 5) = 50,00,000
• Since we are retiring the oldbonds, we will get the tax benefit by expensing the balancefloatation cost immediately. Tax benefit on expensing the balancefloatation cost = Balance floatation cost x tax rate = 50,00,000 x40% = 20,00,000
• Since there is a time gap of 1month between the new bond issue and retiral of old bonds, we willhave to continue to pay the interest on the old bond issue for thisone month. However this interest will also give us an interest taxshield. Hence, post tax interest on old bonds for 1 month = FaceValue x interest rate of old bond x 1 / 12 x (1 - Tax rate) =500,00,000 x 14% x 1 / 12 x (1 - 40%) = 350,000
• New bonds issued will be investedin short-term government securities returning 7% annually duringthe interim period of 1 month. However this interest income will besubjected to tax as well. Hence, post tax interest income = Facevalue of new bond issue x short term government securities interestrate x 1 / 12 x (1 - Tax rate) = 50,000,000 x 7% x 1/12 x (1 -40%) = 175,000

Thus, total initial investmentoutlay = Post tax call premium paid + New floatation cost - Taxsavings by expensing the balance floatation costs on old bonds +post tax interest paid on old bonds in the interim period of 1month - post tax interest earned on proceeds from new bond issueinvested in short-term government securities during the interimperiod of 1 month = 27,00,000 + 50,00,000 - 20,00,000 + 350,000 - 175,000 = 58,75,000. Please note that this is an outlay i.e. acash outflow .

Part 2: Figure out annual cashflows. This comprises of two sub parts:

• Figure out total amortization taxeffects
  • Annual floatation cost on new issue = Total floatation cost ofnew issue / Life of new issue = 50,00,000 / 25 = 2,00,000
  • Annual floatation cost foregone on old issue = Total floatationcost of old issue / Life of old issue = 60,00,000 / 30 =200,000
  • Incremental annual floatation cost that will be amortised =200000 - 200,000 = 0
  • Total amortization tax effect = Tax saved due to incrementalannual floatation cost amortisation= 0 x Tax rate = 0 x40% = 0
• Figure out net post tax interestsavings
  • Annual interest on old bonds = 500,00,000 x 14% =70,00,000
  • Annual interest on new bonds = 500,00,000 x 11% =55,00,000
  • Annual interest saved = 70,00,000 - 55,00,000 = 15,00,000
  • Net Post tax interest saving = Pre tax interest saving x (1 -Tax rate) = 15,00,000 x (1 - 40%) = 9,00,000

Thus annual cash flow = totalamortization tax effects + Net Post tax interest saving = 0 + 9,00,000 = 900,000

Part 3: We are now ready tocalculate NPV

Initial investment outlay (ascalculated in part 1 above) = 58,75,000

Annual post tax cash inflows = 9,00,000 (as calculated in part 2 above)

NPV = - Initial investment + PV ofall the future annual post tax cash inflows

For PV of all the future annual posttax cash inflows:

Discount Rate = short-termgovernment securities rate = 7%

Period = 25 years

Payment = 9,00,000

Use excel function "PV" to calculatethe PV of all the future annual post tax cash inflows = PV (Rate,Period, Payment, FV) = PV(7%, 25, 9,00,000,0)= 104,88,224.86

Hence, NPV = - Initial investment + PV of all the future annual post tax cash inflows = - 5875,000 +104,88,224.86 = $ 46,13,224.86

Hence, the bond refunding's NPV = $46,13,224.86