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Web Appendix 12C - 19819_12Cw_p1-6.qxd 10:39 AM Page 12C-1...

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12C-1 Refunding decisions actually involve two separate questions: (1) Is it profitable to call an outstanding issue in the current period and replace it with a new issue; and (2) even if refunding is currently profitable, would the firm’s expected value be increased even more if the refunding were postponed to a later date? We consider both questions in this appendix. Note that the decision to refund a security is analyzed in much the same way as a capital budgeting expenditure. The costs of refunding (the investment outlays) are (1) the call premium paid for the privilege of calling the old issue, (2) the costs of selling the new issue, (3) the tax savings from writing off the unexpensed flotation costs on the old issue, and (4) the net interest that must be paid while both issues are outstanding (the new issue is often sold prior to the refunding to ensure that the funds will be available). The annual cash flows, in a capital budgeting sense, are the interest payments that are saved each year plus the net tax savings that the firm receives for amortizing the flotation expenses. For example, if the interest expense on the old issue is $1,000,000, whereas that on the new issue is $700,000, the $300,000 reduction in interest savings constitutes an annual benefit. The net present value method is used to analyze the advantages of refunding: the future cash flows are discounted back to the present, and then this discounted value is compared with the cash outlays associated with the refunding. The firm should refund the bond only if the present value of the savings exceeds the cost—that is, if the NPV of the refunding operation is positive. In the discounting process, the after-tax cost of the new debt, r d , should be used as the discount rate . The reason is that there is relatively little risk to the savings—cash flows in a refund- ing decision are known with relative certainty, which is quite unlike the situation with cash flows in most capital budgeting decisions. The easiest way to examine the refunding decision is through an example. McCarty Publishing Company has a $60 million bond issue outstanding that has a 12 percent annual coupon interest rate and 20 years remaining to maturity. This issue, which was sold five years ago, had flotation costs of $3 million that the firm has been amortizing on a straight-line basis over the 25-year original life of the issue. The bond has a call provision that makes it possible for the company to retire the issue at this time by calling the bonds in at a 10 percent call premium. Investment bankers have assured the company that it could sell an additional $60 million to $70 million worth of new 20-year bonds at an inter- est rate of 9 percent. To ensure that the funds required to pay off the old debt will be available, the new bonds will be sold one month before the old issue is called, so for one month, interest will have to be paid on two issues. Current short-term interest rates are 6 percent. Predictions are that long-term interest rates are unlikely to fall below 9 percent. 1 Flotation costs on a new refunding issue will amount to $2,650,000. McCarty’s marginal
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