Question

Problem 18-07
Refunding Analysis

Mullet Technologies is considering whether or not to refund a $50 million, 12% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $6 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 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 11% 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 7% 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.

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

Answer 1

a). NPV of the refunding decision = initial investment outlay + PV of flotation cost + PV of interest savings

The calculations are:

The annual flotation cost tax savings and net interest savings will continue for 25 years (maturity of new debt), so their PVs have to be calculated.

NPV of the refunding decision = -4,412,500.68

The bond should not be refunded as it will lead to a loss.

b). Since interest rates are not expected to fall below 11% any time soon but on the contrary, are expected to rise, Mullet can refund now as later on, if the interest rates increase, the bond can become costlier than the NPV of the decision to refund now.