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UNIT 4 PROFESSIONAL CHALLENGE- INSTRUCTIONS

Hi Everyone,

Be sure to read pages 810-815 on Refunding Operations. Then write a short memo (a few paragraphs) on if Mullet should refund the bond or not. Justify why or why not.

Please use the Professional Challenge-Blank Answer Template to complete the calculations. Be sure to use Excel formulas in all cells. Here are some instructions to help you out:

1. For the Investment Outlay numbers, the Call premium and Flotation costs need to be negative numbers since they are cash outflows. For the call premium on the old bond (before tax), you will multiply the existing bond issue by the call premium %. For the call premium on the old bond (after tax), you will multiply the answer derived from the before tax calculation by (1 minus tax rate).
2. For the Flotation costs on new issue (before tax), it is given data. Be sure to make the amount a negative number. The answer in cell G27 will be the same as in cell F27.
3. For the immediate tax savings on old flotation cost expense (before-tax), you want to subtract the "years since old debt" from "maturity of original debt" and then divide this by "maturity of original debt" and then multiply it by the original flotation cost. For the after-tax, you will multiply the before-tax answer by the tax rate.
4. For the Extra Interest Paid on Old Issue, the number should also be negative. You should multiply the existing bond issue amount by one month (1/12) and multiply it by the original coupon rate. For the after-tax, you will multiply the before-tax answer by (1 - tax rate).
5. For the Interest Earned on Short-term Investment, you want to take the new bond issue and multiply it by the (After tax cost of debt /12 months). For the after-tax, you will multiply the before-tax answer by (1 - tax rate).
6. For the Total After Tax Investment (cell G31), just sum up cells G26 thru G30.
7. For the Annual Tax Savings from New Issue Flotation Costs, you want to divide the New Flotation Cost by the New Bond Maturity. For the after-tax, you will multiply the before-tax answer by the tax rate.
8. For the Annual Lost Tax Savings From Old Issue Flotation Costs, be sure to divide the original Flotation costs by Maturity of the Original Debt for the Before-Tax cell (cell F35). Make sure the Maturity of the Original Debt is negative in the formula since it is a cash outflow. For the After-tax (cell G35), multiply your answer in cell F35 by the tax rate.
9. For the Net Flotation Cost Tax Savings, you just sum up the interest tax savings (or loss) from the new issue flotation costs and the old issue flotation costs.
10. For the Interest on the Old Bond, you multiply the Existing Bond Issue by the Annual Original Coupon Rate. For the after-tax, you will multiply the before-tax answer by (1 - tax rate).
11. Interest on New bond (Before Tax) is the New Bond Issue amount multiplied by the New Cost of Debt. The New Bond issue number should be negative. For After Tax, you multiply cell F40 by (1 - Tax rate).
12. Net Interest Savings should be the sum of the Interest on the Old Bond and New Bond.
13. For cell D54 (NPV of Annual Flotation Cost Savings), you will want to use the After-tax cost of new debt as your Rate and the After-tax net Flotation Cost of Savings as the Pmt input in. Also make sure the Pmt number is negative.
14. For cell I54 (NPV of Annual Interest Savings), you will also want to use the After-tax cost of new debt as your Rate and the Annual Interest Savings as the Pmt input in. Also make sure the Pmt number is negative.
15. For the Bond Refunding NPV inputs, the Initial Outlay = Total-After Tax Investment. The PV of Flotation Costs is the number you calculated in cell D54. The PV of Interest Savings is the number you calculated in cell I54.
16. To find the Bond Refund NPV, you sum up cells C60, E60, & G60.
17. In cells D54 and I54 you will use the Present Value (PV) formula in Excel (not the NPV formula). The Bond Refund NPV answer in cell C62 will be the sum of cells C60, E60, and G60. Again, you will not use the NPV formula in Excel.
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Problem 20-5
Mullet Technologies is considering whether or not to refund a \$75 million, 12% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing \$5 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 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 12% 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%. 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.
A. Perform 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?
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• Unit 4 - Professional Challenge - Blank Answer Template.xlsx
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The solution explains how to do a bond refunding analysis

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• Unit 4 - Professional Challenge - Blank Answer Template.xlsx

REFUNDING OPERATIONS

This example examines the issue of replacing existing debt with newly issued debt. First, "Is it profitable to call an
outstanding issue and replace it with a new issue?". Second, 'even if refunding now is profitable, "Would the
firm's expected value be
The firm should refund only if the present value of the savings exceeds the cost of the refunding. The after-tax
cost of debt should be used as the discount 'rate, since there is relative certainty to the cash flows to be received.
Using the example

Input Data (in thousands of dollars)

Existing bond issue \$75,000 New bond issue \$75,000
Original flotation cost \$5,000 New flotation cost \$5,000
Maturity of original debt 30 New bond maturity 25
Years since old debt issue 5 New cost of debt 10%
Original coupon rate 12% Tax rate 40%
After-tax cost of new debt 6% Short-term interest rate 6%

Schedule of cash flows
Before-tax After-tax
Investment Outlay
Call premium on the old bond
Flotation costs on new issue
Immediate tax savings on old flotation cost expense
Extra interest paid on old issue
Interest earned on short-term investment
Total after-tax investment

Annual Flotation Cost Tax Effects: t=1 to 20
Annual tax savings from new issue flotation costs
Annual lost tax savings from old issue flotation costs
Net flotation cost tax savings

Annual Interest Savings Due to Refunding: t=1 to 20
Interest on old bond
Interest on new bond
Net interest savings

Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they
represent annuities. To evaluate this project, we must find the present values of these savings. Using
the function wizard and solving for present value,

Calculating the annual flotation cost tax effects and the annual interest savings

Annual flotation Cost Tax Effects Annual Interest Savings
Maturity of the new bond (Nper) Maturity of the new bond (Nper)
After-tax cost of new debt (Rate) After-tax cost of new debt (Rate)
Annual flotation cost tax savings (Pmt) Annual interest savings (Pmt)

NPV of annual flotation cost savings NPV of annual interest savings

Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the
present 'values of the annual flotation cost tax effects and interest savings.

Bond Refunding NPV = Initial Outlay + PV of flotation costs + PV of interest savings
Bond Refunding NPV = + +

Bond Refund NPV =