Question

18-7. 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 million 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. 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 12% would be required to retire the old bonds, and flotation costs on the new issue would amount to $5million.Mullet’s marginal federal-plus-state tax rate is 40%.The new bonds would be issued 1month before the old bonds are called, with the proceeds being invested in short-term government securities returning 6% annually during the interim period.

a. Conduct a complete bond refunding analysis. What is the bond refunding’s NPV?

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

Answer 1

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Answer:

Initial investment outlay to refund old issue:	Working/Calculation
Call premium on old issue (75000000x12%)	75000000x12%	a	9,000,000.00
After-tax call premium	9000000x60%	b	5,400,000.00
New flotation cost	as given	c	5,000,000.00
Old flotation costs already expensed	(5000000x5/30)	d	833,333.33
Remaining flotation costs to expense	(5000000-833333.33)	e	4,166,666.67
Tax savings from old flotation costs	4166666.67x40%	f	1,666,666.67
Additional interest on old issue after tax	(75000000x12%)x1/12x60%	g	450,000.00
Interest earned on investment in T-bonds after tax	(75000000x6%)x1/12x60%	h	225,000.00
Total investment outlay	b+c-f+g-h		8,958,333.33
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation	(5000000 x 40%/ 25 )		80,000.00
Tax savings lost on old flotation	(5000000 x 40%/ 30)		66,666.67
Total amortization tax effects	(80000 - 66666.67)		13,333.33
Annual interest savings due to refunding:
Annual after tax interest on old bond	(75000000X12%X60%)		5,400,000.00
Annual after tax interest on new bond	(75000000X10%X60%)		4,500,000.00
Net after tax interest savings	(5400000-4500000)		900,000.00
Annual cash flows	(13333.33+900000)		913,333.33
NPV of refunding decision	(8958333.33-PV OF ANNUAL CASH FLOWS)		2,717,131.96
	PV OF ANNUAL CASH FLOW = 913333.33 x [1-(1+r)^-25]/r

b)

Factors influencing Mullet's decision