LONG-TERM DEBT
Refunding Decision
When interest rates have fallen and the bond is callable, it may be advantageous for the
company to call in the old bonds and issue new bonds at the newer rate of interest (like
refinancing a mortgage on your home). The primary benefit is the lower rate of interest that is
paid. On the other hand, there are many costs associated with a bond refunding, including the
call premium that must be paid, the flotation costs on a new issue, overlapping interest on the
two bond issues between the time when the new bonds are issued and the old bonds are
recalled, and differences between amortizations of flotation costs.
The next page contains a general format for constructing the relevant cash flows used in
determining whether a bond refunding is advantageous or not. Note the similarity to the
Purchase/Replacement format that we encountered previously during Capital Budgeting (this is,
after all, a capital investment project itself).
CASH FLOW ANALYSIS
BOND REFUNDING DECISION
A.
B.
C.
D.
E.
F.
Today
Intervening Years
Last Year
├────────────────────────────────────┼───────────────────────────────────────┤
<Call premium on old issue, 1-t>
G. Net interest savings
I. <Maturity value of new bonds>
<Flotation costs of new issue>
H. Less: Change in amortization J. Maturity value of old bonds
---------------------------Write-off unamortized flotation
Change in taxable income
costs of old issue, t
Less: Taxes
<Overlapping interest, 1-t>
---------------------------Change in net Income
Cash proceeds from new bond issue
in excess of cost to refund old
Plus: Change in amortization
bond issue, if different1
----------------------------Change in operating cash flow
Tax effect of accounting gain
(loss) on refunding/exchanging
the bonds2
1If
proceeds from the new bond issue are greater than the money needed to refund the old bond issue, the
company will receive additional cash equal to: Proceeds from the new issue minus cash needed to retire
the old issue (face value). There is no tax effect on this occurrence. For example, an old bond issue in
the amount of $10,000,000 is "called" by the company and the company issues new bonds in the amount of
$10,500,000. The company, therefore, receives an additional cash inflow of $500,000 in year zero.
2The
accounting treatment for bond refunds and exchanges is governed by Accounting Principles Board
Opinion No. 6, "Early Extinguishment of Debt".
For a complete discussion of this topic, refer to a
comprehensive Intermediate Accounting textbook.
The appropriate discount rate used for determining the Net Present Value is generally deemed to be the
after-tax interest rate of the new debt. For example, if the new debt carries a coupon rate of 10% and
the applicable tax rate is 40%, the discount rate employed would be 10% * (1-.4) = 6%.
< > indicates that the cash flow is an outflow.
t = applicable tax rate