Refunding Analysis Mullet Technologies is considering whether or not to refund a

Question

Refunding Analysis

Mullet Technologies is considering whether or not to refund a $125 million, 14% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $8 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 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 15% would be required to retire the old bonds, and flotation costs on the new issue would amount to $6 million. Mullet's marginal federal-plus-state tax rate is 30%. 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 6% annually during the interim period.

a.) Conduct a complete bond refunding analysis. What is the bond refunding's NPV? Round your answer to the nearest cent.

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

Explanation / Answer

b)

Bond Refunding Analysis Current bond issue information Par value 125,000,000 coupon rate 14.00% original maturity 30 remaining maturity 25 original flotation costs 8,000,000 Call premium 15% Tax rate 30% New issue information Coupon rate 10% maturity 25 flotation costs 6,000,000 Time between issues (months) 1 rate on surplus funds (annual) 6% a. Perform a complete bond refunding analysis. What is the bond refunding's NPV? Initial investment outlay to refund old issue: Call premium on old issue = $125,000,000 x 15% 18,750,000.00 After-tax call premium = $18,750,000 x (1- 30%) 13,125,000.00 New flotation cost = 6,000,000.00 Old flotation costs already expensed = $8,000,000/25 x (30-25) 1,333,333.33 Remaining flotation costs to expense = $8,000,000 -$1,333,333.33 6,666,666.67 Tax savings from old flotation costs = 6,666,666.67 x 30% 2,000,000.00 Additional interest on old issue after tax = $125,000,000 x 14% x 1/12 x (1-30%) 1,020,833.33 Interest earned on investment in T-bonds after tax =($125,000,000 x 6% x 1/12 x(1-30%) 437,500.00 Total investment outlay = $13,125,000+6,000,000-$2,000,000+ $1,020833.33 - $437500 17,708,333.33 Annual Flotation Cost Tax Effects: Annual tax savings on new flotation = $6,000,000 x 30%/25 72,000.00 Tax savings lost on old flotation = (8,000,000 x 30%/30 80,000.00 Total amortization tax effects = (72000 - 80000) (8,000.00) Annual interest savings due to refunding: Annual after tax interest on old bond = $125,000,000 x 14% x (1- 30%) 12,250,000.00 Annual after tax interest on new bond =$125,000,000 x 10% x (1-30%) 8,750,000.00 Net after tax interest savings = (12,250,000 - 8,750,000) 3,500,000.00 Annual cash flows = (-$8000 + $3,500,000) 3,492,000.00 NPV of refunding decision = - 17708333.33 + PV(6%,25,-3492000,0) 26,931,146.37

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