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Unformatted text preview: WEB APPENDIX 12B
Refunding decisions involve two separate questions: (1) Is it profitable to call an
outstanding issue in the current period and replace it with a new issue? (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 Web 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
The net present value method is used to analyze the advantages of refunding:
The future cash flows are discounted back to the present; 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, rd , should be used as the
discount rate. There is relatively little risk to the savings—cash flows in a refunding
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% annual coupon interest rate and 20 years remaining to maturity. This issue,
which was sold 5 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% 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 interest rate of 9%. To ensure that
the funds required to pay off the old debt will be available, the new bonds will be
sold 1 month before the old issue is called; so for 1 month, interest will have to be
paid on two issues. Current short-term interest rates are 6%. Predictions are that
long-term interest rates are unlikely to fall below 9%.1 Flotation costs on a new
refunding issue will amount to $2,650,000. McCarty’s marginal federal-plus-state
tax rate is 40%. Should the company refund the $60 million of 12% bonds?
The following steps outline the bond refunding decision process; they are summarized in the spreadsheet in Table 12B-1. This spreadsheet is part of the spreadsheet
model developed for Chapter 12. Click on the tab labeled Bond Refunding at the
bottom of the chapter model to view the bond refunding model. Rows 8 through
14 show input data needed for the analysis, which were just discussed.
The firm’s management has estimated that interest rates will probably remain at their present level of 9%;
otherwise, they will rise. There is only a 25% probability that they will fall further.
1 12B-1 12B-2 Web Appendix 12B Table 12B-1 7
53 Spreadsheet for the Bond Refunding Decision A
Input Data (in thousands of dollars)
Existing bond issue
Original flotation cost
Maturity of original debt
Years since old debt issue
Call premium (%)
Original coupon rate
After-tax cost of new debt D E F G H
9% New bond issue
New flotation cost
New bond maturity
New cost of debt $60,000
5.4% I Tax rate
Short-term interest rate 40%
6% Cash flow schedule
300 Annual Flotation Cost Tax Effects: t = 1 to 20
Annual tax savings from new issue flotation costs
Annual lost tax savings from old issue flotation costs
Net flotation cost tax savings
Annual Interest Savings Due to Refunding: t = 1 to 20
Interest on old bond
Interest on new bond
Net interest savings After-tax
$ 13 Investment Outlay
Call premium on the old bond
Flotation costs on new issue
Immediate tax savings on old flotation cost expense
Extra interest paid on old issue
Interest earned on short-term investment
Total after-tax investment $53
$1,080 Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they
represent annuities. To evaluate this project, we must find the present values of these savings.
Using the function wizard and solving for present value, we find that the present values of these
Calculating the annual flotation cost tax effects and the annual interest savings
Annual Flotation Cost Tax Effects
Maturity of the new bond
After-tax cost of new debt
Annual flotation cost tax savings Annual Interest Savings
Maturity of the new bond
After-tax cost of new debt
Annual interest savings 20
$5 NPV of annual interest savings $60 NPV of flotation cost savings 20
$13,014 Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the present values of the
annual flotation cost tax effects and interest savings. Bond Refunding NPV =
Bond Refunding NPV = Initial Outlay
($5,470) Bond Refunding NPV = $7,604 +
+ PV of flot. costs
+ PV of interest savings
$13,014 Web Appendix 12B Step 1: Determine the Investment Outlay Required
to Refund the Issue
Row 19. Call premium on old issue:
Before tax : 0:10ð$60,000,000Þ ¼ $6,000,000
After tax : $6,000,000ð1 À TÞ ¼ $6,000,000ð0:6Þ
¼ $3,600,000 Although McCarty must spend $6 million on the call premium, this is a deductible
expense in the year the call is made. Because the company is in the 40% tax bracket, it
saves $2.4 million in taxes; therefore, the after-tax cost of the call is only $3.6 million.
Row 20. Flotation costs on new issue:
Flotation costs on the new issue will be $2,650,000. This amount cannot be
expensed for tax purposes, so it provides no immediate tax benefit.
Row 21. Flotation costs on old issue:
The old issue has an unamortized flotation cost of (20/25)($3,000,000) ¼ $2,400,000
at this time. If the issue is retired, the unamortized flotation cost may be recognized immediately as an expense, thus creating an after-tax savings of $2,400,000
(T) ¼ $960,000. Because this is a cash inflow, it is shown as a positive number.
Rows 22 and 23. Additional interest:
One month’s “extra” interest on the old issue, after taxes, costs $360,000:
ðDollar amountÞð1=12 of 12%Þð1 À TÞ ¼ Interest cost
ð$60,000,000Þð0:01Þð0:6Þ ¼ $360,000 However, the proceeds from the new issue can be invested in short-term securities
for 1 month. Thus, $60 million invested at a rate of 6% will return $180,000 in aftertax interest:
ð$60,000,000Þð0:06=12Þð1 À TÞ ¼ Interest earned
ð$60,000,000Þð0:005Þð0:6Þ ¼ $180,000 Thus, the net after-tax additional interest cost is $180,000:
Interest paid on old issue
Interest earned on short-term securities
Net additional interest ($360,000)
($180,000) Row 24. Total after-tax investment:
The total investment outlay required to refund the bond issue, which will be
financed by debt, is thus $5,470,000:2
Flotation costs, new
Flotation costs, old, tax savings
Net additional interest
Total investment ($3,600,000)
The investment outlay (in this case, $5,470,000) is usually obtained by increasing the amount of the new
bond issue. In the example given, the new issue would be $65,470,000. However, the interest on the additional
debt should not be deducted at Step 3 because the $5,470,000 will be deducted at Step 4. If additional interest
on the $5,470,000 was deducted at Step 3, interest would, in effect, be deducted twice. The situation here is
exactly like that in regular capital budgeting decisions. Even though some debt may be used to finance a project,
interest on that debt is not subtracted when the annual cash flows are developed. Rather, the annual cash flows
are discounted at the project’s cost of capital. 12B-3 12B-4 Web Appendix 12B Step 2: Calculate the Annual Flotation Cost Tax Effects
Row 27. Tax savings on flotation costs on the new issue:
For tax purposes, flotation costs must be amortized over the life of the new bond,
or for 20 years. Therefore, the annual tax deduction is as follows:
20 The spreadsheet shows dollars in thousands, so this number appears as 133 on the
spreadsheet. Because McCarty is in the 40% tax bracket, it has a tax savings
of $132,500(0.4) ¼ $53,000 a year for 20 years. This is an annuity of $53,000 for
Row 28. Tax benefits lost on flotation costs on the old issue:
The firm, however, will no longer receive a tax deduction of $120,000 a year for
20 years; so it loses an after-tax benefit of $48,000 a year.
Row 29. Net amortization tax effect:
The after-tax difference between the amortization tax effects of flotation on the
new and old issues is $5,000 a year for 20 years. Step 3: Calculate the Annual Interest Savings
Row 32. Interest on old bond, after tax:
The annual after-tax interest on the old issue is $4.32 million:
ð$60,000,000Þð0:12Þð0:6Þ ¼ $4,320,000 Row 33. Interest on new bond, after tax:
The new issue has an annual after-tax cost of $3,240,000:
ð$60,000,000Þð0:09Þð0:6Þ ¼ $3,240,000 Row 34. Net annual interest savings:
Thus, the net annual interest savings is $1,080,000:
Interest on old bonds, after tax
Interest on new bonds, after tax
Annual interest savings, after tax $4,320,000
$1,080,000 Step 4: Determine the NPV of the Refunding
Row 45. PV of the benefits:
The PV of the annual after-tax flotation cost benefit of $5,000 a year for
20 years is $60,251, and the PV of the $1,080,000 annual after-tax interest savings
for 20 years is $13,014,174.3
We can also solve for the present value of the benefits by using a financial
calculator. To determine the present value of the after-tax flotation cost benefit,
enter the following data into your calculator: N ¼ 20; I/YR ¼ 5.4; PMT ¼ À5000;
FV ¼ 0. Then solve for PV ¼ $60,250.80 % $60,251.
To determine the present value of the after-tax interest savings, enter the
following data into your calculator: N ¼ 20; I/YR ¼ 5.4; PMT ¼ À1080000; FV ¼ 0.
Then solve for PV ¼ $13,014,173.78 % $13,014,174.
Note that the spreadsheet uses Excel’s PV function to solve for the present values of the annual flotation cost and
interest savings. 3 Web Appendix 12B These values are used to find the NPV of the refunding operation:
Amortization tax effects
Net investment outlay
NPV from refunding $ 60,251
$ 7,604,425 Because the net present value of the refunding is positive, it will be profitable to
refund the old bond issue.
We can summarize the data shown in Table 12B-1 using a time line (amounts
in thousands) as shown here: Time period 0 1 2 20
••• After-tax investment
Flotation cost tax effects
Net cash flows
1,085 NPV5.4% ¼ $7,604 Several other points should be made. First, because the cash flows are based
on differences between contractual obligations, their risk is the same as that of
the underlying obligations. Therefore, the present values of the cash flows
should be found by discounting at the firm’s least risky rate—its after-tax cost of
marginal debt. Second, the refunding operation is advantageous to the firm.
Thus, it must be disadvantageous to bondholders; they must give up their 12%
bonds and reinvest in new ones yielding 9%. This points out the danger of the
call provision to bondholders, and it explains why bonds without a call feature
command higher prices than callable bonds. Third, although it is not emphasized
in the example, we assumed that the firm raises the investment required to
undertake the refunding operation (the $5,470,000 shown on Row 24 of Table
12B-1) as debt. This should be feasible because the refunding operation will
improve the interest coverage ratio even though a larger amount of debt is
outstanding.4 Fourth, we set up our example in such a way that the new issue
had the same maturity as the remaining life of the old one. Often the old bonds
have a relatively short time to maturity (e.g., 5 to 10 years), whereas the new
bonds have a much longer maturity (e.g., 25 to 30 years). In such a situation, the
analysis should be set up similarly to a replacement chain analysis in capital
budgeting, which is discussed in Fundamentals of Financial Management, 12th
edition, Chapter 12, or in Concise Fundamentals, 6th edition, Web Appendix 12E.
Fifth, refunding decisions are well suited for analysis with a computer spreadsheet program. Spreadsheets such as the one shown in Table 12B-1 are easy to set
up; and once the model has been constructed, it is easy to vary the assumptions
(especially the assumption about the interest rate on the refunding issue) and to
see how such changes affect the NPV.
One final point should be addressed: Although our analysis shows that the
refunding will increase the firm’s value, would refunding at this time truly maximize the firm’s expected value? If interest rates continue to fall, the company
See Ahron R. Ofer and Robert A. Taggart, Jr., “Bond Refunding: A Clarifying Analysis,” Journal of Finance, March
1977, pp. 21–30, for a discussion of how the method of financing the refunding affects the analysis. Ofer and
Taggart prove that if the refunding investment outlay is to be raised as common equity, the before-tax cost of
debt is the proper discount rate, whereas if these funds are to be raised as debt, the after-tax cost of debt is
the proper discount rate. Since a profitable refunding usually raises the firm’s debt-carrying capacity (because
total interest charges after the refunding are lower than before the refunding), it is more logical to use debt than
either equity or a combination of debt and equity to finance the operation. Therefore, firms generally do
use additional debt to finance refunding operations. 4 12B-5 12B-6 Web Appendix 12B might be better off waiting, for this could increase the NPV of the refunding
operation even more. The mechanics of calculating the NPV in a refunding are
easy, but the decision of when to refund is not simple at all because it requires a
forecast of future interest rates. Thus, the final decision on refunding now versus
waiting for the possibility of a more favorable time is a judgmental decision. QUESTIONS
12B-3 How does refunding analysis compare to standard capital budgeting analysis?
What is the appropriate discount rate to use in refunding analysis? Why?
If a refunding analysis shows that a refund would have a positive NPV, should the firm
always proceed with the bond refund? Explain. PROBLEMS
12B-1 REFUNDING ANALYSIS JoAnn Vaughan, financial manager of Gulf Shores Transportation
(GST), has been asked by her boss to review GST’s outstanding debt issues for
possible bond refunding. Five years ago GST issued $40,000,000 of 11%, 25-year debt.
The issue, with semiannual coupons, is currently callable at a premium of 11%, or $110 for
each $1,000 par value bond. Flotation costs on this issue were 6%, or $2,400,000.
Vaughan believes that GST could issue 20-year debt today with a coupon rate of 8%.
The firm has placed many issues in the capital markets during the last 10 years, and
its debt flotation costs are currently estimated to be 4% of the issue’s value. GST’s
federal-plus-state tax rate is 40%. Help Vaughan conduct the refunding analysis
by answering the following questions:
g. h. 12B-2 What total dollar call premium is required to call the old issue? Is it tax deductible?
What is the net after-tax cost of the call?
What is the dollar flotation cost on the new issue? Is it immediately tax deductible?
What is the after-tax flotation cost?
What amount of old-issue flotation costs has not been expensed? Can these deferred
costs be expensed immediately if the old issue is refunded? What is the value of the tax
What is the net after-tax cash outlay required to refund the old issue?
What semiannual tax savings arises from amortizing the flotation costs on the new
issue? What is the forgone semiannual tax savings on the old-issue flotation costs?
What semiannual after-tax interest savings would result from the refunding?
Thus far Vaughan has identified two future cash flows: (1) the net of new issue flotation
cost tax savings and old issue flotation cost tax savings that are lost if refunding occurs
and (2) after-tax interest savings. What is the sum of these two semiannual cash flows?
What is the appropriate discount rate to apply to these future cash flows? What is the
present value of these cash flows?
What is the NPV of refunding? Should GST refund now or wait until later? Why? REFUNDING ANALYSIS Tarpon Technologies is considering whether to refund a $75 million,
12% coupon, 30-year bond issue that was sold 5 years ago. The company is amortizing
$5 million of flotation costs on the 12% bonds over the issue’s 30-year life. Tarpon’s investment
bankers have indicated that the company could sell a new 25-year issue at an interest rate
of 10% in today’s market. Neither they nor Tarpon’s management anticipates that interest
rates will fall below 10% any time soon, but there is a chance that rates will increase.
A call premium of 12% would be required to retire the old bonds, and flotation costs on the
new issue would amount to $5 million. Tarpon’s marginal federal-plus-state tax rate is 40%.
The new bonds would be issued 1 month before the old bonds are called, with the proceeds being
invested in short-term government securities returning 6% annually during the interim period.
a. Perform a complete bond refunding analysis. What is the bond refunding’s NPV? b. What factors would influence Tarpon’s decision to refund now rather than later? ...
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- Fall '06