\'Mullet Technologies is considering whether or not to refund a $75 million, 12
ID: 2779548 • Letter: #
Question
'Mullet Technologies is considering whether or not to refund a $75 million, 12 percent coupon, 30 year bond issue that was sold 5 years ago. It is amortizing $5 million of flotation costs on the 12 percent bonds over the issue's 30-year life. Mullet's investment bankers have indicated that the company could sell a new 25-year issue at an interest rate of 10 percent in today's market. Neither they nor Mullet's management anticipate that interest rates will fall below 10 percent any time soon, but there is a chance that interest rates will increase.
A call premium of 12 percent would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Mullet's marginal federal-plus-state tax rate is 40 percent. 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 percent annually during the interim period.
A - Conduct a complete bond refunding analysis. What is the bond refunding's NPV?
B - What factors would influence Mullet's decision to refund now rather than later?
Explanation / Answer
1) Under Present Situation, every year cost is
Interest Cost - 75*12% = 9 millions
Floation Cost = 5/30 = 0.17 millions
2) If 12%Bonds are replaced by New Bonds(10%)
Present Floation cost/per year = 0.17 Millions (as cal. above)
Call Premium = 75*12% = 9 millions =9/25==0.36 per year
Flotation cost for new issue = 5 millions = 5/25 = 0.20 per year
After Tax net cost for new issuue (.17+.36+.20)-40%(tax Rate)
= 0.436
Interest received from Govt sec for 1 Month (assuming Tax Free) = 75*6% for 1 month
= 0.375 millions
So, Net increase cost in present terms = 0.061 millions
Net Decrease in Interest payout is = (75*12%)-(75*10%)
= 1.5 Millions
After Tax = 1.5 - 40% (Tax Rate)
= 0.9 Millions
(B) Other factors like Bank Rate, Costs involved in new issue and investors interest in the new issue are also to be taken care off while taking such decisions.
It is better to take such decision as early as possible, as the floatation cost already paid off has to be writte off for the next years further new floation cost and refunding back cost are to be set off within the time spam of life of bonds.
So, is such decision is taken at later stage, floatation cost per year will got higher than the interst benefit.
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