Mullet Technologies is considering whether or not to refund a $75 million, 12% c
ID: 2750858 • Letter: M
Question
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 the 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 reture 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%. The new bonds would be issues 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? b. What factors would influence Mullet’s decision to refund now rather than later?
Explanation / Answer
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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