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.’
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Source: Cengage Learning
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