Chapter 24 The Many Different Kinds of Debt 625
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price, for that would just be giving a present to the bondholders. Equally, a company should
call the bond if it is worth more than the call price.
Of course, investors take the call option into account when they buy or sell the bond. They
know that the company will call the bond as soon as it is worth more than the call price, so no
investor will be willing to pay more than the call price for the bond. The market price of the
bond may, therefore, reach the call price, but it will not rise above it. This gives the company
the following rule for calling its bonds: Call the bond when, and only when, the market price
reaches the call price.^18
If we know how bond prices behave over time, we can modify the basic option-valuation
model of Chapter 21 to find the value of the callable bond, given that investors know that the
company will call the issue as soon as the market price reaches the call price. For example,
look at Figure 24.3. It illustrates the relationship between the value of a straight 8% five-year
bond and the value of a comparable callable bond. Suppose that the value of the straight
bond is very low. In this case there is little likelihood that the company will ever wish to call
its bonds. (Remember that it will call the bonds only when their price equals the call price.)
Therefore the value of the callable bond will be almost identical to the value of the straight
bond. Now suppose that the straight bond is worth exactly 100. In this case there is a good
chance that at some time the company will wish to call its bonds. Therefore the value of
our callable bond will be slightly less than that of the straight bond. If interest rates decline
further, the price of the straight bond will continue to rise, but nobody will ever pay more than
the call price for the callable bond.
A call provision is not a free lunch. It provides the issuer with a valuable option, but that is
recognized in a lower issue price. So why do companies bother with a call provision? One rea-
son is that bond indentures often place a number of restrictions on what the company can do.
Companies are happy to agree to these restrictions as long as they know that they can escape
from them if the restrictions prove too inhibiting. The call provision provides the escape route.
We mentioned earlier that some bonds also provide the investor with an option to demand
early repayment. Puttable bonds exist largely because bond indentures cannot anticipate every
(^18) Of course, this assumes that the bond is correctly priced, that investors are behaving rationally, and that investors expect the firm to
behave rationally. Also we ignore some complications. First, you may not wish to call a bond if you are prevented by a nonrefunding
clause from issuing new debt. Second, the call premium is a tax-deductible expense for the company but is taxed as a capital gain to
the bondholder. Third, both the company and the investor face other possible tax consequences from replacing a high-coupon bond
with a lower-coupon bond. Fourth, calling and reissuing debt involves costs and delays.
◗ FIGURE 24.3
Relationship between the value
of a callable bond and that of
a straight (noncallable) bond.
Assumptions: (1) Both bonds have
an 8% coupon and a five-year
maturity; (2) the callable bond may
be called at face value any time
before maturity; (3) the short-term
interest rate follows a random
walk, and the expected returns on
bonds of all maturities are equal.
Source: M. J. Brennan and E. S. Schwartz,
“Savings Bonds, Retractable Bonds, and
Callable Bonds,” Journal of Financial
Economics 5 (1977), pp. 67–88. © 1977.
Value of bond
0
25
50
75
100
125
150
Value of straight bond
0255075 100 125 150
Callable bond
Straight bond