Question

Refunding Analysis

Mullet Technologies is considering whether or not to refund a $50 million, 15% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $9 million of flotation costs on the 15% 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 10% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 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 6% 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

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VO x ENG 06:20 101 2000 = 13 AAZ/ x for - N P Q R S T U V W X Y Z AA AB I 273 274 MULLET step 1 investment outlay required to refund the issue call premium on old issue 50000000 x 10% = 5000000 call premium on old issue after tax 5000000*(1-0.4) = 278 3000000 outflow 279 280 281 new floatation cost = 3000000 outflow 282 283 284 old flotation cost= 9000000 [ 30 years life) per year cost = 300000.00 25 years life outstanding 25 years flotation cost = 7500000 tax saving on old flotation cost = 7500000 X 40% 3000000 inflow 285 286 287 288 289 after tax additional interest for 1 month 50000000 x 15% x (1/12)*(1-0.4) 375000 outflow 290 interest on investment value of new bonds issued = after tax return for 1 month = 50000000 50000000 x 6% x (1/12) x (1-0.4) = 150000 inflow 291 292 293 294 295 296 297 298 299 net cash outflow = 3225000 step 2 annual cash flows flotation cost on new issue 3000000 flotation cost per year = 120000 (3000000/25) tax savings on above costs = 120000 X 40% = 48000 BANKING NOTE 51 53 CLEAN PRICE $10 BIDDING, UNDERWRITING EUAC AW LIFE 300 301 ... Sheet2 AFN LP, IP, MRP, INFLATION WARRANT refund 54 55 56 57 58 - 6

VL x W 0621 E ENG 2101 2020 E3 AA324 X V fx - N O T U V W X Y Z AA AB a 297 step 2 298 P Q R S annual cash flows flotation cost on new issue flotation cost per year = tax savings on above costs = 120000 X 40% = 299 300 301 3000000 120000 (3000000/25] 48000 302 303 304 305 If refund is done, deduction of flotation cost forgone = deduction of flotation cost forgone = tax saving lost on above costs = 7500000/25 300000.00 120000.00 (300000 x 40%] 306 307 308 amortization tax effect = 48000 - 120000 = -72000.00 309 interest on old issue = 50000000 x 15% after tax interest payments = 7500000 4500000 310 311 312 interest on new issue = 50000000 x 10% = after tax interest payments = 313 4500000 2700000 after tax net interest saving = 4500000 - 2700000 = 1800000 net cash inflow 1728000.00 314 315 316 317 318 319 320 321 322 323 present value all cash inflows 1728000 x PVIFA @6%, 25 YEARS 1728000 x (1/r)*(1-(1/(1+r)^n)) 1728000 X (1/0.06)*(1-(1/(1+0.06)^25)) = 1728000 x 12.783356 = 324 22089639.44 325 Sheet2 AFN BANKING NOTE 51 53 CLEAN PRICE 510 | BIDDING, UNDERWRITING EUAC AW LIFE LP, IP, MRP, INFLATION WARRANT refund S4 S5 S6 S7 S8 ...

VL x W 0621 E ENG 2101 2020 E3 AA343 X V - N fx O P Q R S T U V 316 317 net cash inflow 1728000.00 318 319 321 322 323 present value all cash inflows 1728000 x PVIFA @6%, 25 YEARS 1728000 x (1/r)*(1-(1/(1+r)^n)) 1728000 x (1/0.06)*(1-(1/(1+0.06)^25)) = 1728000 x 12.783356 = 324 22089639.44 325 326 327 NPV = NPV = PV OF ALL CASH INFLOWS - OUTFLOWS 22089639.44 - 3225000 = 18864639.44 328 ANSWER:a: 329 330 331 ANSWER:b: 332 333 334 335 IN OUR CASE, NPV IS POSITIVE AND AMOUNT IS BIG ONE SO REFUND SHOULD BE DONE REFUND SHOULD BE DONE LATER IF RATE OF INTEREST COMES DOWN BECAUSE IN THAT CASE, INTEREST SAVINGS MAY MAKE NPV OF REFUNDING STILL HIGHER 336 337 338 339 340 341 342 343 344 Sheet2 AFN BANKING NOTE 51 53 CLEAN PRICE 510 | BIDDING, UNDERWRITING EUAC AW LIFE LP, IP, MRP, INFLATION WARRANT refund S4 S5 S6 S7 S8 ...