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Refunding Decision: Writing Assessment Two

Ashley L. Filapose

Seton Hill University
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Refunding Decision: Writing Assessment Two

Making the decision to refinance debt is financially important to any company with

outstanding debt obligations and is a key component in capital budgeting. The refunding

operation affords a company the opportunity to take advantage of lower interest rates that were

not present at the time they issued the debt. In the case of the given problem for this assignment,

I would choose to refinance the debt because the net effect of the present values of inflows and

outflows results in a net present value of $4,076,529. Throughout this paper I will analyze and

identify different aspects of this refinancing problem that will show how I arrived at my decision

as well as additional considerations that a company may take into account before they decide to

carryout a refunding operation. First, I will expand on some additional sources that aided me in

my understanding of the refunding decision and brought to light different viewpoints on this

topic.

Literature Review

The 2012 article published by the Public Finance Review entitled, “State and Local

Government Bond Refinancing and the Factors Associated with the Refunding Decision,”

explores how the refunding decision plays a large role in state and government entities by

analyzing state local government bond refinancing in California. This article was informative in

that it presented the process of bond refunding in a real-world scenario and showed how bond

refunding works with different types of entities. Government entities have to assess refinancing

very critically because they are limited in their abilities by the IRS and the potential economic

gain from the decision can be very large. The authors explored trends in the bond market and

found that refunding bonds made up roughly between 20 and 30% of the total market for

municipal bonds in the years analyzed. The results of their study showed that issuers rely on
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market characteristic to determine if they should refinance, and that they more likely expect

interest rates to rise in the future. They state however, that while these findings confirm why the

refunding decision should be made, they do not give any indication of how issuers are weighing

the potential opportunity costs (Moldogaziev & Luby, 2012). For a state or governmental entity,

opportunity costs and risks would heavily factor into any capital budgeting decision, being that

their budgets are dedicated to large-scale projects for society as a whole.

Another article entitled, “Insuring Callable Bonds: Selecting the Right Payment Plan,”

discusses that insured callable bonds attract investors because of their security, and after deciding

to insure a bond, a corporation should consider which premium plan would be most cost

effective. The amount of the premium paid on insured bonds depends upon the bond rating; such

as if the bond rating is low, the premium will be higher. Premiums that are paid upfront in one

single payment are like sunk costs, similar to the underwriting fees of the bond, and would not

have any influence on a corporation’s decision to recall a bond. In this case though, upfront

premiums would have some effect when it comes to taxes. If premiums are paid on a pay-as-you-

go method, the cost of the bond becomes higher, since premium payments would get tacked onto

the coupon amount in order to calculate the interest cost after the call period has ended (Kalotay

& Abreo, 2003). The topic presented in this article would be an additional consideration to think

about when dealing with the theoretical refunding decision discussed within this paper. Had the

original $25 million existing debt been insured, the type of premium payments the corporation

was paying may influence whether or not the corporation would have recalled the debt in the first

place. In the end, the decision the corporation makes needs to be cost effective, and by utilizing

the lower interest rates, should put them in a better position financially by saving money.
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Discussion

In arriving at the decision to refinance the bond in the problem presented for this

assessment, calculating the present values of inflows and outflows from the potential refinancing

were the key underlying factors to arriving at the NPV. Following is the presentation of how

each inflow and outflow was arrived at in order to make a final decision as well some additional

information to consider about the problem, such as uncertainty and debt financing’s affect on a

corporation as a whole.

Inflows vs. Outflows

The first step to this bond-refunding problem was to calculate the outflows of the

operation. First, the payment of call premium is a tax-deductible expense, which is why the tax

rate of 30% and the call premium of 5% play roles in arriving at the net cost. On an after-tax

basis at a tax rate of 30%, the net cost is equal to $875,000. One thing to consider in terms of the

call premium is the fact that had the tax rate been higher than 30%, the net cost would be

materially less. For instance if the tax rate had been 40%, the result would have been a net cost

of only $750,000. This shows that multiple factors of the corporation and its industry can

influence a bond-refunding decision. The second outflow calculated is that of the underwriting

cost on the new issue, which while also tax-deductible, has to be spread over the life of the bond.

Spreading the cost over the remaining 20 years of the new issue resulted in annual tax savings of

$3,750, the present value of the these savings being $36,818. By taking this out of the initial

underwriting cost of $250,000, the net cost of the new underwriting issue works out to be

$213,182, which means the total present value of outflows is equal to $1,088,182 (computation

of these amounts is included in the appendix in Figures 1 and 2).
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In terms of inflows, the cost savings in the lower interest rates and the underwriting cost

of the old issue are calculated. Interest rates theoretically dropped 3% and resulted initially in a

savings of $750,000, which on an after-tax basis is equal to $525,000. By applying the discount

rate of 8%, the cost savings is equal to a total of $5,154,52. This inflow is heavily influence by

both the tax rate and discount rate, which again shows how many factors play into bond

refunding. When looking at the underwriting cost of the old issue, there is approximately

$66,667 not yet amortized, since its remaining life is 20 years. When the present value of those

future write-offs not taken is subtracted from this amount, the gain on the immediate write-off is

found to be approximately $33,340, which when multiplied by the 30% tax rate, results in a net

gain of $10,182. This brings the total inflows from the operation to $5,164,711 (computation of

these amounts is included in the appendix in Figures 3 and 4).

The Net Present Value

After calculating both the total present values of inflows and outflows, it can be seen that

inflows exceed outflows, which results in a net present value of $4,076,529 (calculation can be

seen in Figure 5 in the appendix). This shows that the best decision would be to proceed in

refinancing the existing long-term debt, and that interest rates have dropped enough in the

market to yield a beneficial return on the operation. Had the NPV in this situation been negative,

it would have been best to wait to refinance until interest rates have dropped to a lower percent,

seeing as the potential gain in present day dollars would have been less than the cost of the

operation, or the present value of the outflows.

Uncertainty and Debt Financing in Capital Budgeting

A number of other factors would go into considering whether or not a company should

refinance existing long-term debt. While it seems smart to refinance when interest rates drop
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since there is a potential for these rates to climb higher, there is also a chance rates could drop

even more. This shows that uncertainty can never be perfectly eliminated from a given decision,

and that there is always a possibility that a better decision could have been made. The benefits

and drawbacks of debt financing should also be considered, which are discussed in Chapter 16 of

Foundations of Financial Management. One of the benefits that relates most to this problem

would be that using debt could lower the cost of capital for a firm. The text states that, “To the

extent that debt does not strain the risk position of the firm, its low after-tax cost may aid in

reducing the weighted overall cost of financing…(Bartley, Geoffrey, & Stanley, 2014)” This

shows that inflows from tax savings and using the refunding operation could put a corporation in

a better position financially with a stable capital structure. One drawback that relates most to this

problem is that “indenture agreements can place burdensome restrictions on a firm (Bartley,

Geoffrey, & Stanley, 2014).” It is important for a company to consider all their debt and equity

obligations before making any capital budgeting decisions because they are all interrelated, and

restrictions from one may have influence over the others and what decisions the corporation

decides to make.

Conclusion

Overall, the refunding decision is a complex operation to conduct and requires a

corporation to be financially savvy in their choices. Attempting to make the most of changing

market conditions can aid a corporation in their endeavors, but also must be approached with

caution due to uncertainty. Refinancing existing long-term debt may seem like an easy decision

when looking at dropping interest rates, but in reality refinancing debt takes many aspects of a

corporation and its industry into consideration before a well-informed decision can be made.
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References

Bartley, R. D., Geoffrey, A. H., & Stanley, B. B. (2014). Chapter 16: Long-Term Debt and Lease

Financing. In Bathurst, N., Maloney, M. B., & Shanahan, K. Foundations of Financial

Management (505-544). New York, NY: McGraw-Hill Education.

Kalotay, A., & Abreo, L. (2003). Insuring Callable Bonds: Selecting the Right Payment Plan.

Journal Of Risk Finance (Euromoney Institutional Investor PLC), 4(3), 82-86.

Moldogaziev, T. T., & Luby, M. J. (2012). State and Local Government Bond Refinancing and

the Factors Associated with the Refunding Decision. Public Finance Review, 40(5), 614

642. doi:10.1177/1091142111430954
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Appendix

Figure 1: Outflow from the Payment of the Call Premium

Figure 2: Outflow from Underwriting Cost of the New Issue and the Total PV of Outflows
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Figure 3: Inflow from the Cost Savings in Lower Interest Rates

Figure 4: Inflow from Underwriting Cost on the Old Issue
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Figure 5: The Net Present Value of the Refunding Decision