Deciding to Refund Bonds

Deciding to Refund Bonds

Refunding occurs when an entity that has issued callable bonds calls those debt securities from the debt holders with the express purpose of reissuing new debt at a lower coupon rate. In essence, the issue of new, lower-interest debt allows the company to prematurely refund the older, higher-interest debt. On the contrary, nonrefundable bonds may be callable, but they cannot be re-issued with a lower coupon rate (i.e., they cannot be refunded).

French Bond : a French Bond for the Akhtala mines issued in 1887.

The decision to refund a particular debt issue is usually based on a capital budgeting (present value) analysis. The principal benefit, or cash inflow, is the present value of the after-tax interest savings over the issue's life.

Bond refunding occurs when all three of the following are true

1. 1Interest rates in the market are sufficiently less than the coupon rate on the old bond
2. 2The price of the old bond is less than par.
3. 3The sinking fund has accumulated enough money to retire the bond issue.

The three steps of whether to make a refunding decision are as follows:

Step 1: Calculate the present value of interest savings (cash inflows):

Interest savings = annual interest of old issue - annual interest of new issue

Step 2: Calculate the net investment (net cash outflow at time 0). This involves computing the after-tax call premium, the issuance cost of the new issue, the issuance cost of the old issue, and the overlapping interest. The call premium is a cash outflow.

Step 3: Finally, calculate the net present value of refunding.

Net present value of refunding = Present value of interest savings - Present value of net investment

Key Points

• The issue of new, lower-interest debt allows the company to prematurely refund the older, higher-interest debt.
• Bond refunding occurs when a) interest rates in the market are sufficiently less than the coupon rate on the old bond, b) the price of the old bond is less than par. and c) the sinking fund has accumulated enough money to retire the bond issue.
• The decision of whether to refund a particular debt issue is usually based on a capital budgeting (present value) analysis.

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