Question

Problem 18-07
Refunding Analysis

Mullet Technologies is considering whether or not to refund a $175 million, 15% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 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 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $7 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.

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

Answer 1

In absence of any specific information about the cost of capital, we assume that the company is using a borrowing to finance the net outflow.

There fore Discounting rate = After tax cost of new debt

= 10℅[1-40%]

= 6%