Foundations of Financial Management: An Analysis (part 61)

Money often costs too much. 

--Ralph Waldo Emerson

Investment Banking (part E)

by

Charles Lamson

The Refunding Decision 

Assume you are the financial vice-president for a corporation that has issued bonds at 11.75 percent, only to witness a drop in interest rates to 9.5 percent. If you believe interest rates will rise rather than sink further, you may wish to redeem the expensive 11.75 percent bonds and issue new debt at the prevailing 9.5 percent rate. This process is labeled a refunding operation. It is made feasible by the call provisions that enable a corporation to buy back bonds at close to par, rather than at high market values, when interest rates are declining.

A Capital Budgeting Problem

The refunding decision involves outflows in the form of financing costs related to redeeming and reissuing securities, and inflows represented by savings in annual interest costs and tax savings. In the present case, we shall assume the corporation issued $10 million worth of 11.75 percent debt with a 25-year maturity and the debt has been on the books for 5 years. The corporation now has the opportunity to buy back the old debt at 10 percent above par (the call premium) and to issue new debt at 9.5 percent interest with a 20-year life. The underwriting cost for the old issue was $125,000, and the underwriting cost for the new issue is $200,000. We also assume the corporation is in the 35 percent tax bracket and uses a 6 percent discount rate for refunding decisions. Since the savings from a refunding decision are certain---unlike savings from most other capital budgeting decisions---we use the aftertax cost of new debt as the discount rate, rather than the more generalized cost of capital. Actually, in this case, the aftertax cost of new debt is 9.5 percent (1 - tax rate), or 9.5% X 0.65 = 6.18%. We round to 6 percent. The facts in this example are restated as follows.

Restatement of facts

Let's go through the capital budgeting process of defining our outflows and inflows and determining the net present value.

Step A---Outflow Considerations

1. Payment of call premium---The first outflow is the 10 percent call premium on $10 million, or $1 million. This prepayment penalty is necessary to call in the original issue. Being an out-of-pocket tax deductible expense, the $1 million cash expenditure will cost us only $650,000 on an aftertax basis. We multiply the expense by (1 - tax rate) to get the aftertax cost.

$1,000,000 (1 - T) = $1,000,000 (1 - 0.35) = $650,000

Net cost of call premium = $650,000

2. Underwriting cost on new issue---The second outflow is the $200,000 underwriting cost on the new issue. The actual cost is somewhat less because the payment is tax deductible, though the write-off must be spread over the life of the bond. While the actual $200,000 is being spent now, equal tax deductions of $10,000 a year will occur over the next 20 years (in a manner similar to depreciation).

The tax savings from a noncash write-off are equal to the amount times the tax rate. For a company in the 35 percent tax bracket, $10,000 of annual tax deductions will provide $3,500 of tax savings each year for the next 20 years. The present value of these savings is the present value of a $3,500 annuity for 20 years at 6 percent interest:

$3,500 X 11.470 (n = 20, i = 6%) equals $40,145

The cost of underwriting the new issue is the actual expenditure now, minus the present value of future tax savings as indicated below.

Step B---Inflow Considerations

The major inflows in the refunding decision are related to the reduction of annual interest expense and the immediate write-off of the underwriting cost on the old issue.

3. Cost savings and lower interest rates---The corporation will enjoy a 2.25 percentage point drop in interest rates, from 11.75 percent to 9.50 percent, on $10 million of bonds.

Since we are in the 35 percent tax bracket, this is equivalent to $146,250 of aftertax benefits per year for 20 years. We have taken the savings and multiplied by one minus the tax rate to get the annual after-tax benefits.

Applying a 6 percent discount rate for a 20-year annuity:

$146,250 X 11.470 (n = 20, i = 6%) = $1,677,488

 Cost savings in lower interest rates . . . $1,677,488

4. Underwriting cost on old issue---There is a further cost savings related to immediately writing off the remaining underwriting costs on the old bonds. Note that the initial amount of $125,000 was spent five years ago and was to be written off for tax purposes over 25 years at $5,000 per year. Since 5 years have passed, $100,000 of old underwriting costs have not been amortized as indicated in the following: 

A tax benefit is associated with the immediate write-off of old underwriting costs, which we shall consider shortly.

Note, however, that this is not a total gain. We would have gotten the $100,000 additional write-off eventually if we had not called in the old bonds. By calling them in now, we simply take the write-off sooner. If we extended the write-off over the remaining life of the bonds, we would have taken $5,000 a year for 20 years. Discounting this value, we show:

$5,000 X 11.470 (n = 20, i equals 6%) = $57,350

Thus, we are getting a write-off of $100,000 now, rather than a present value of future write-offs of $57,350. The gain in immediate tax write-offs is $42,650. The tax savings from a noncash tax write-off equal the amount times the tax rate. Since we are in the 35 percent tax bracket, our savings from this write-off are $14,928. The following calculations, which were discussed above, are necessary to arrive at $14,928.

Net gain from the underwriting on the old issue ......................   $14,928

Step C---Net Present Value

We now compare our outflows and our inflows.

The refunding decision has a positive net present value, suggesting that interest rates have dropped to a sufficiently low level to indicate refunding is in order. The only question is, will interest rates go lower indicating an even better time for refunding? There is no easy answer: conditions in the financial markets must be carefully considered.

A number of other factors could be plugged into the problem. For example, there could be overlapping time periods in the refunding procedure when both issues are outstanding and the firm is paying double interest (hopefully for less than a month). A dollar amount in these cases, however, tends to be small and is not included in the analysis.

And working problems, you should have minimum difficulty if you follow the four suggested calculations. In each of the four calculations we had the following tax implications:

1. Payment of call premium---the cost equals the amount times (1 - Tax rate) for this cash tax-deductible expense.

2.  Underwriting costs on new issue---we pay an amount now and then amortize it over the life of the bond for tax purposes. The subsequent amortization is similar to depreciation and represents a noncash write-off of a tax-deductible expense. The tax saving from the amortization is equal to the amount times the tax rate.

3.  Cost savings in lower interest rates---cost savings are like any form of income, and will retain the cost of savings times (1 - Tax rate).

4.  Underwriting cost on old issue---once again, the writing off of underwriting costs represents a non-cash write-off of a tax-deductible expense. The tax savings from the amortization are equal to the amount times the tax rate. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 476-480*

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