Refunding Analysis Mullet Technologies is considering whether or not to refund a
ID: 2717013 • Letter: R
Question
Refunding Analysis
Mullet Technologies is considering whether or not to refund a $75 million, 13% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 million of flotation costs on the 13% 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 9% in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 9% 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 $4 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 7% annually during the interim period.
Conduct a complete bond refunding analysis. What is the bond refunding's NPV? Round your answer to the nearest cent.
$ _____________
What factors would influence Mullet's decision to refund now rather than later?
Refunding Analysis
Mullet Technologies is considering whether or not to refund a $75 million, 13% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 million of flotation costs on the 13% 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 9% in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 9% 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 $4 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 7% annually during the interim period.
Conduct a complete bond refunding analysis. What is the bond refunding's NPV? Round your answer to the nearest cent.
$ _____________
What factors would influence Mullet's decision to refund now rather than later?
Explanation / Answer
The bond refunding analysis can be prepared as below:
Current bond issue
Par value
$ 7,50,00,000
Coupon rate
13%
Original maturity
30
Remaining maturity
25
Original flotation costs
$ 30,00,000
Call premium
15%
Tax rate
30%
New issue information
Coupon rate
9.00%
Maturity
25
Flotation costs
$ 40,00,000
Interim period between issues
1 month
Rate for surplus funds (annual)
7%
For calculating the NPV of bond refunding, we have to find the annual savings from issue of new bonds and also the initial outflow of funds:
Initial outflow of funds = Call premium on retiring old bonds + Flotation cost of new issue + Interest on old bonds for interim period of one month
Call premium on old issue (after tax) = $75,000,000 * 15% *(1-0.30) = $7,875,000
Flotation cost of new issue = $4,000,000
Interest on old issue for interim period = $75,000,000 * 13% * 1/12 * (1 - 0.30) = $568,750
Initial Outflow of funds = $7,875,000 + $4,000,000 + $568,750 = $12,443,750
Intial savings due to new issue = Tax savings on flotation cost of old bonds + Interest on investment in government security for interim period
Remaining Flotation cost of old bonds = ($3,000,000/30) * 25 = $2,500,000
Tax savings on flotation cost of old bonds = $2,500,000 * 0.30 = $750,000
Interest on investment in government security for interim period = {$7,500,000 * 7% * (1-0.30)} / 12 = $306,250
Intial savings due to new issue = $750,000 + $306,250 = $1,056,250
Net intital outlay = $12,443,750 - $1,056,250 = $11,387,500
Annual inflow = Annual interest savings + Annual tax savings on amortisation of flotation cost
Annual post tax interest on new bonds = $75,000,000 * 9% * (1 - 0.30) = $4,725,000
Annual post tax interest on old bonds = $75,000,000 * 13% * (1- 0.30) = $6,825,000
Annual interest savings = $6,825,000 - $4,725,000 = $2,100,000
Tax savings on amortisation of flotation cost of new bonds = ($4,000,000 / 25) * 0.30 = $48,000
Tax savings on amortisation of flotation cost of old bonds = ($3,000,000 / 30) * 0.30 = $30,000
Net Tax savings on amortisation of flotation cost = $48,000 - $30,000 = $18,000
Annual inflow = $2,100,000 + $18,000 = $2,118,000
Present value of annual inflows discounted at 7% for 25 years = $24,682,289.17
NPV = - $11,387,500 + $24,682,289.17 = 13,294,789.17
Current bond issue
Par value
$ 7,50,00,000
Coupon rate
13%
Original maturity
30
Remaining maturity
25
Original flotation costs
$ 30,00,000
Call premium
15%
Tax rate
30%
New issue information
Coupon rate
9.00%
Maturity
25
Flotation costs
$ 40,00,000
Interim period between issues
1 month
Rate for surplus funds (annual)
7%
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