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
Today Intervening Years Last Year
├────────────────────────────────────┼───────────────────────────────────────┤
A. <Call premium on old issue, 1-t> G. Net interest savings I. <Maturity value of new bonds>
B. <Flotation costs of new issue> H. Less: Change in amortization J. Maturity value of old bonds
----------------------------
C. Write-off unamortized flotation Change in taxable income
costs of old issue, t
Less: Taxes
D. <Overlapping interest, 1-t> ----------------------------
Change in net Income
E. 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
F. 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