\'Mullet Technologies is considering whether or not to refund a $75 million, 12
ID: 2710638 • Letter: #
Question
'Mullet Technologies is considering whether or not to refund a $75 million, 12 percent coupon, 30 year bond issue that was sold 5 years ago. It is amortizing $5 million of flotation costs on the 12 percent bonds over the issue's 30-year life. Mullet's investment bankers have indicated that the company could sell a new 25-year issue at an interest rate of 10 percent in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 10 percent any time soon, but there is a chance that interest rates will increase.
A call premium of 12 percent 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 percent. 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 percent 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?
If you can show work in Excel, that would be extremely helpful as I am a visual learner. I think I am having the most difficulty reconciling the answer in the book for part A. The book says the answer for Part A is $2,717,128 but I keep getting $2,621,687.
Thank you!!!!
Explanation / Answer
Solution :
A..Bond Refunding Analysis
Summary of Present Bond
Par value
75000000
coupon rate
12%
original maturity
30
remaining maturity
25
original flotation costs
5000000
Call premium
12%
Tax rate
40%
Summary of New Bond
Coupon rate
10%
maturity
25
flotation costs
5000000
Time between issues (months)
1
rate on surplus funds (annual)
6%
Calculation of NPV of refunding :
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 to refund now rather than later:
1
Interest rates are now at a lower level than they were when the bonds were issued.
2
The bond issuer can obtain replacement debt that carries fewer restrictions than are imposed in the bond agreements.
3
Positive bond refunding NPV
A..Bond Refunding Analysis
Summary of Present Bond
Par value
75000000
coupon rate
12%
original maturity
30
remaining maturity
25
original flotation costs
5000000
Call premium
12%
Tax rate
40%
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