Bond Refundinga Clooser LookBonds may be refunded by the company prior to maturity through either the issuance of a serial bond or exercising a call privilege on a straight bond. The issuance of serial bonds allows the company to refund the debt over the life of the issue. A call feature in a bond enables the issuer to retire it before the expiration date. The call feature is included in many corporate bond issues.

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This post discuss bond refunding in more detail with some case example. Enjoy!

 

When future interest rates are anticipated to decline, a call provision in the bond issue is recommended. Such a provision enables the firm to buy back the higher-interest bond and issue a lower-interest one. The timing for the refunding depends on expected future interest rates. Read on… 

A call price is usually established in excess of the face value of the bond. The resulting call premium equals the difference between the call price and the maturity value. The issuer pays the premium to the bondholder in order to acquire the outstanding bonds before the maturity date.

The call premium is generally equal to 1 year’s interest if the bond is called in the first year, and it declines at a constant rate each year thereafter. Also involved in selling a new issue are flotation costs. Both the call premium and flotation costs are tax-deductible expenses.

 

A bond with a call provision typically will be issued at an interest rate higher than one without the call provision. The investor prefers not to have a situation where the company can buy back the bond at its option prior to maturity. This is because the company will tend to buy back high-interest bonds early and issue lower-interest bonds when interest rates decline. The investor would obviously want to hold onto a high-interest bond when prevailing interest rates are low.

 

Case Example-1

A $100,000, 10 percent, 20-year bond is issued at 95. The call price is 102. Four years after issue the bond is called. The call premium is equal to:

Call price                  = $102,000
Face value of bond   =-$100,000
Call premium            = $   2,000

 
Case Example-2

A $40,000 callable bond was issued. The call price is 104. The tax rate is 35 percent. The after-tax cost of calling the issue is:

$40,000 x 0.04 x 0:65 = $1,040

Note: The desirability of refunding a bond requires present value analysis.

 
Case Example-3

Lie Dharma Corporation has a $20 million, 10 percent bond issue outstanding that has 10 years to maturity. The call premium is 7 percent of face value. New 10-year bonds in the amount of $20 million can be issued at an 8 percent interest rate. Flotation costs associated with the new issue are $600,000.

Refunding of the original bond issue should take place as shown below:

Old interest payments
($20,000,000 x 0.10)        = $2,000,000
New interest payments
($20,000,000 x 0.08)        = ($1,600,000)
Annual savings                 = $    400,000

Call premium
($20,000,000 x 0.07)        = $1,400,000
Flotation cost                            600,000
Total cost                          = $2,000,000
Year                 Calculation               Present Value

Year 0             – $2,000,000×1          -$2,000,000
Years 1–10         $  400,000×6.71*)   +$2,684,000
Net present value                                $   684,000

Note: *) Present value of annuity factor for i=8%, n=10.

 

Example

Putra Corporation is considering calling a $10 million, 20-year bond that was issued 5 years ago at a nominal interest rate of 10 percent. The call price on the bonds is 105. The bonds were initially sold at 90. The discount on bonds payable at the time of sale was, therefore, $1 million and the net proceeds received were $9 million. The initial flotation cost was $100,000. The firm is considering issuing $10 million, 8 percent, 15-year bonds and using the net proceeds to retire the old bonds. The new bonds will be issued at face value. The flotation cost for the new issue is $150,000. The company’s tax rate is 46 percent. The after-tax cost of new debt ignoring flotation costs, is 4.32 percent (8% x 54%). With the flotation cost, the after-tax cost of new debt is estimated at 5 percent.

There is an overlap period of 3 months in which interest must be paid on the old and new bonds.

 

The initial cash outlay is:

Cost to call old bonds
($10,000,000 x 105%)                              $10,500,000
Cost to issue new bond                                   150,000

Interest on old bonds for overlap period

($10,000,000 x 10% x 3/12)                           250,000
Initial cash outlay                                     $10,900,000

 

The initial cash inflow is:

Proceeds from selling new bond                                           $10,000,000
Tax-deductible items
Call premium                                                     $500,000
Unamortized discount
($1,000,000 x 15/20)                                           750,000
Overlap in interest
($10,000,000 x 10% x 3/12)                                 250,000
Unamortized issue cost of old bond
($100,000 x 15/20)                                                75,000
Total tax-deductible items                              $1,575,000
Tax rate                                                                    x 0.46
Tax savings                                                                           $      724,500
Initial cash inflow                                                                  $ 10,724,500

 

The net initial cash outlay is therefore:

Initial cash outlay         = $10,900,000
Initial cash inflow        =  -10,724,500
Net initial cash outlay  = $     175,500

 

The annual cash flow for the old bond is:

Interest (10% x $10,000,000)                                     $1,000,000
Less: Tax-deductible items
Interest                                          $1,000,000
Amortization of discount
($1,000,000/20 years)                          50,000
Amortization of issue cost
($100,000/20 years)                               5,000
Total tax-deductible items            $1,055,000
Tax rate                                                  x 0.46
Tax savings                                                                    485,300
Annual cash outflow with old bond                              $514,700

 
The annual cash flow for the new bond is:

Interest                                                                        $800,000
Less: Tax-deductible items
Interest                                                 $800,000
Amortization of issue cost
($150,000/15 years)                                 10,000
Total tax-deductible items                   $810,000
Tax rate                                                      x 0.46
Tax savings                                                                   372,600
Annual cash outflow with new bond                           $427,400

 

The net annual cash savings with the new bond compared to the old bond is:

Annual cash outflow with old bond       $514,700
Annual cash outflow with new bond        427,400
Net annual cash savings                         $ 87,300

 

The net present value associated with the refunding is:

                        Calculation               Present Value
Year 0              -$175,500×1             -$175,500
Years 1–15        $  87,300×10.38*)    +$906,174
Net present value                                 $730,674

Note: *) Present value of annuity factor i=5%, n=15,=PVIFA5,15

 

Since a positive net present value exists, the refunding of the old bond should be made. “Sinking fund” requirements may exist with regard to a bond issue.

With a sinking fund, the company is required to set aside money to purchase and retire a portion of the bond issue each year. Usually, there is a mandatory fixed amount that must be retired, but occasionally the retirement may relate to the company’s sales or profit for the current year. If a sinking fund payment is not made, the bond issue may be in default.

In many cases, the company can handle the sinking fund in one of the following two ways:

  • It can call a given percentage of the bonds at a stipulated price each year, for example, 5 percent of the original amount at a price of $1,080.
  • It can buy its own bonds on the open market.

 

The least expensive alternative should be selected. If interest rates have increased, the price of the bonds will have decreased, and the open market option should be used. If interest rates have decreased, the bond prices will have increased, and so calling the bonds is the preferred choice.

 

Example 

Lie Dharma Company has to reduce bonds payable by $300,000. The call price is 104. The market price of the bonds is 103. The company will elect to buy back the bonds on the open market because it is less expensive, as indicated below:

Call price ($300,000 x 104%)           $312,000
Purchase on open market
($300,000 x 103%)                           $309,000

Advantage of purchasing bonds
on the open market                         – $ 3,000