Question

Problem 18-07 Refunding Analysis Mullet Technologies is considering whether or not to refund a $175 million, 12 Coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $6 million of flotation costs on the 12 bonds over the issue's 30-year fe. Muller's investment banks have indicated that the company could sell a new 25-year issue at an interest rate of 11% in today's market. Neither they nor Hullet's management anticipate that interest rates will fall below 11% any time soon, but there is a chance that rates will increase. A call premium of 9% would be required to retire the old bonds, and flotation costs on the new issue would amount to $6 milion. 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 annually during the interim period. a. Conduct a complete bond refunding analysis. What is the band refunding's NPV? Do not round Intermediate calculations. Round your answer to the nearest cent. b. What factors would influence Mullet's decision to refund now rather than later?

Answer 1

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v 14.10 ENG 11 0120204 R140 i XVfx N M O P Q R S T U V W X Y Z AA A 140 MULLET step 1 investment outlay required to refund the issue call premium on old issue 175000000 x 9% = 15750000 call premium on old issue after tax 15750000 x (1 -0.40) = 9450000 outflow new floatation cost = 6000000 outflow 146 147 148 149 150 151 old flotation cost= 6000000 ( 30 years life] per year cost = 200000.00 25 years life outstanding 25 years flotation cost = 5000000 tax saving on old flotation cost = 5000000 X 40% 152 2000000 inflow 153 154 155 after tax additional interest for 1 month 175000000 x 12% x (1/12)*(1-0.4) 1050000 outflow interest on investment value of new bonds issued = after tax return for 1 month = 175000000 175000000 x 7% x (1/12)x(1-0.4) = 612500 inflow net cash outflow = 13887500 step 2 164 165 166 167 annual cash flows flotation cost on new issue flotation cost per year = tax savings on above costs = 240000 X 40% = 6000000 240000 [6000000/25] 96000 168 YIELD SPOT Sheel2 AFN BANKING NOTE 51 53 CLEAN PRICE S10 BIDDING, UNDERWRITING EUAC AW LIFE LP, IP, MRP, INFLATION WARRANT refund 54 55 ... :

1 e 9 X v 14.10 ENG 11 0120204 R190 i XVfx N M O P Q R S T U V W X Y Z AA a 163 164 step 2 annual cash flows flotation cost on new issue flotation cost per year = tax savings on above costs = 240000 X 40% = 6000000 240000 [6000000/25] 96000 167 168 169 170 171 If refund is done, deduction of flotation cost forgone = deduction of flotation cost forgone = tax saving lost on above costs = 5000000/25 200000.00 80000.00 172 173 174 amortization tax effect = 16000.00 175 176 interest on old issue = 175000000 x 12% after tax interest payments = 21000000 12600000 177 178 interest on new issue = 175000000 x 11% = after tax interest payments = 19250000 11550000 after tax net interest saving = 12600000 - 11550000 = 1050000 net cash inflow 1066000.00 187 188 189 present value all cash inflows 1066000 x PVIFA @7%, 25 YEARS 1066000 x (1/r)*(1-(1/(1+r)^n)) 1066000 X (1/0.07)*(1- (1/(1+0.07) 25)) = 1066000 x 11.653583 = BANKING NOTE 51 53 CLEAN PRICE S10 BIDDING, UNDERWRITING 190 191 YIELD SPOT Sheet2 AFN 12422719.67 EUAC AW LIFE LP, IP, MRP INFLATION WARRANT refund S4 S5 ... :

v 14.10 ENG 11 0120204 R211 2 184 i XVfx N M O P Q R S T U V W X Y Z AA A 785 net cash inflow 1066000.00 186 187 188 189 190 191 present value all cash inflows 1066000 x PVIFA @7%, 25 YEARS 1066000 x (1/r)*(1-(1/(1+r)^n)) 1066000 x (1/0.07)*(1-(1/(1+0.07)^25)) = 1066000 X 11.653583 = 12422719.67 192 193 194 NPV = NPV = PV OF ALL CASH INFLOWS - OUTFLOWS 12422719.67 - 13887500 ANSWER:a: -1464780.33 196 197 ANSWER:b: 198 199 IN OUR CASE, NPV IS NEGATIVE SO REFUND SHOULD NOT BE DONE REFUND SHOULD BE DONE LATER IF RATE OF INTEREST COMES DOWN BECAUSE IN THAT CASE, INTEREST SAVINGS MAY MAKE NPV OF REFUNDING POSITIVE 208 209 210 211 212 MOSO will neverwe were a recome A CHRISTINE ORE ANCHE e dag weater Lam YIELD SPOT Sheel2 AFN BANKING NOTE 51 53 CLEAN PRICE S10 BIDDING, UNDERWRITING EUAC AW LIFE LP, IP, MRP, INFLATION WARRANT refund S4 S5 ... :