Question

Mullet Technologies is considering whether or not to refund a $200 million, 12% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $3 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 11% in today's market. Neither they nor Mullet'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 8% 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 5% annually during the interim period. a. 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. $ b. What factors would influence Mullet's decision to refund now rather than later?

Answer 1

Step 2: Calculate the Annual Flotation Cost Tax Effects Tax savings/loss on flotation costs Annual tax deduction Tax savings Net tax effect Note: For tax purposes, flotation costs must be amortized over the life of the new bond, or for 25 years. Therefore, the annual tax deduction is The firm will no longer receive a tax deduction of $100,000 a year for 30 years, so it loses an after-tax benefit of $40,000 a year. For old bond 0.1 0.04 0.024 0.16 V-F/C 0.064 W-VG Annuity AD=W-W 0.938086 0.880006 0.825521 0,77441 0.726464 0.681486 0.639292 0.599711 0.562581 0.52775 0.49507!5 0.464423 0.435669 Step 3: Calculate the Annual Interest Savings Annual Interest After Tax Savings after tax 24.00 14.4 1.2 22.00 X=A"B 13.2 Y X11-G) Step 4: Determine the NPV of the Refunding PV of the benefits PV of the annual after-tax flotation cost benefit After tax interest rate of new bond 6.60% Z-B"(1-6) 25 C Payment Present Value of annuity PV of the annual after-tax annual interest savings After tax interest rate of new bond 0.024 AD 290,060.19 M-AD AC SODO 0.10869 6.60% z-B"(1-G) 25.U0 C 6.6096 0.383391 20 0.359651 5066.415 0.33386 Payment Present Value of .20 A 0.31649 14,503,009.58 Al-(*AC 0.296902 0.27857 0.261276 0.245099 0.229924 0.215689 0.202334 12.08584 AC Arnortication tax effects Interest savings Net investment outlay 290,060.19 AA 14,503,009.58 AB (6,400,000.00) L 8,393,069.7