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 $9 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 interest rates will fall below 10% 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 $4 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 4% 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.

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

Answer 1

a]

The initial investment outlay to refund the old issue = after-tax call premium on old issue + new flotation cost - tax savings from old flotation costs + additional interest on old issue after tax - interest earned on investments in interim period

after-tax call premium on old issue = par value of old issue * call premium * (1 - tax rate)

tax savings from old flotation costs = (old flotation costs - old flotation costs already expensed) * tax rate

additional interest on old issue after tax = interest paid on old bonds during interim period

interest earned on investments in interim period = interest earned on proceeds of new bonds during interim period

Annual incremental cash flows = After-tax interest savings + Flotation cost amortization tax effects

After-tax interest savings = after-tax interest on new bonds - after-tax interest on old bonds

Flotation cost amortization tax effects = annual tax savings on new flotation - tax savings lost on old flotation

NPV of bond refunding = present value of annual incremental cash flows - initial investment outlay

In calculating the present value of annual incremental cash flows, the discount rate used is the rate of return earned on short-term investments in the interim period (4%)

NPV of bond refunding = $6,935,035.47

b]

The decision to refund now rather than later would depend on their expectation of interest rates. If the interest rates are expected to rise in the future, they would rather refund now to take advantage of the lower interest rates.