Introduction to Corporate Finance

14: Long-Term Debt and Leasing

14 -3g BOND REFUNDING OPTIONS

In the absence of a sinking-fund requirement, a company that wishes to avoid a large single repayment

of principal in the future or to refund (refinance) a bond before maturity has two options. Both require

foresight and careful analysis on the part of the issuer.

Serial Issues

The borrower can issue serial bonds, a certain proportion of which mature each year. When companies

issue serial bonds, they attach different interest rates to bonds maturing at different times. Although

serial bonds cannot necessarily be retired at the option of the issuer, they do permit the issuer to retire

the debt systematically.

Exercising a Call

If interest rates drop following the issuance of a bond, the issuer may wish to refund the debt with new

bonds at the lower interest rate. If a call feature has been included in the issue, then the issuer can easily

retire it. In an accounting sense, bond refinancing will increase earnings per share by lowering interest

expense. Of course, the desirability of refunding a bond through exercise of a call is not necessarily

obvious, and assessing its long-term consequences requires the use of present value techniques.

This bond refunding decision is another application of the capital budgeting techniques described in

Chapters 10 and 11.

Here the company must find the net present value (NPV) of the bond-refunding cash flows. The

initial investment is the incremental after-tax cash outflows associated with calling the old bonds and

issuing new bonds, and the annual cash flow savings are the after-tax cash savings that are expected from

the reduced debt payments on the new lower-interest bond. These cash flows are the same each year.

The resulting cash flow pattern surrounding this decision is typical: an outflow followed by a series of

inflows. The bond-refunding decision can be made using the following three-step procedure.

■ Step 1 Find the initial investment by estimating the incremental after-tax cash outflow required at

time 0 to call the old bond and issue a new bond in its place. Any overlapping interest resulting from

the need to pay interest on both the old and new bonds is treated as part of the initial investment.

■ Step 2 Find the annual cash flow savings, which is the difference between the annual after-tax debt

payments with the old and new bonds. This cash flow stream will be an annuity, with a life equal to

the maturity of the old bond.

■ Step 3 Use the after-tax cost of the new debt (as the discount rate) to find the net present value

(NPV) by subtracting the initial investment from the present value of the annual cash flow savings.

The annual cash flow savings is a contractually fixed cash flow stream that represents the difference

between two contractual debt-service streams, the old bond and the new bond. Therefore, the

appropriate discount rate should reflect the risk of the company’s debt (which is tied to these same

contractually fixed cash flows). That is, we discount these cash flows at the company’s cost of debt.

Moreover, we follow convention and use the after-tax cost of debt as the discount rate. If NPV is

positive, then the proposed refunding is recommended; otherwise, the bonds should not be refunded.

Application of this bond refunding decision procedure is illustrated in the ‘Example’ that follows.

First, however, a few tax-related points must be clarified.

refund

To refinance a debt with new

bonds

serial bonds

Bonds of which a certain

portion mature each year

Ed Altman, New York

University

‘Probably about 75% of

the bonds are investment

grade; that’s BBB or

higher.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

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