WELCOME TO THE SECESSION OF

Refunding of Bond and Preferred stock

M. K. Mandal
9851115045
Meaning and concept
 What is refunding?
Answer: - Refunding is the process of replacing
existing bond or preferred stock before its maturity
with new and less costly bond or preferred stock.

 Who refund to whom?

Answer : - The issuer to the holder
Meaning and concepts
 Which bonds or preferred stocks can be refunded?
Answer : - The exiting bonds and preferred stocks which
were issued with a call provision.

 What is call provision?

Answer: it is a feature of bond or preferred stock which
gives the issuing firm the right to refund the bond or
preferred stock before its maturity in exchange of call
price (par value plus call premium)
Meaning and concepts
 When to refund?
Answer: When market interest rate significantly fall and new
issued must have less restrictive covenants.

 How to evaluate refunding decision?

Answer:- It is similar to NPV of capital budgeting evaluation
technique.
Meaning and concepts

 What are the steps in refunding evaluation?

Answer:-
Step 1. find net cost of refunding or initial net cash outlay (NCO)
Step 2. determine annual saving after tax.
Step 3. calculate total present value (TPV) of annual saving after tax.
Step 4. find net present value (NPV) = TPV – NCO
Step 5. conclusion:- refund the existing bond or preferred stock and
replace by new if refunding has positive NPV.
 Calculation of net cost of refunding or initial net cash outlay
(NCO)
 Call premium after taxes
[ face value of old × % call premium × ( 1 – T) ] ………………………………………… Rs XXX
 Flotation costs on new issue …………………………………………………………………… XXX
 Tax saving on unamortized flotation cost on the old issue
X Remaining life X T ………………………………………..
 After tax interest on old during overlap period (XXX)
[face value of old X interest rate of old X overlap period in year X (1 – T)] ……….
 After tax interest income from short term securities during overlap period XXX
face value of new X short term interest rate X overlap period in year X (1 – T)
(XXX)

Initial net cash outlay (NCO)…………………………………………………………………………. XXX

 Calculation of annual saving after tax
 Annual interest saving after tax
[ face value of old × (new interest rate – old interest rate) × ( 1 – T) ] Rs XXX
 Annual tax saving on flotation costs on new issue
( X T ) ………………………………………………………… XXX
 Annual tax saving lost on flotation costs of old issue
( X T) ……………………………………….. (XXX)

Annual saving after tax …………………………………………………. XXX

Annual saving after tax …………………………………………………. XXX
Calculation of TPV of annual saving and NPV

 TPV of annual saving = annual saving after tax X (PVIFA, Kdt of new, n)
= Rs XXX
 Net present value (NPV) = TPV – NCO
= Rs XXX

 Conclusion : Refunding is valuable if NPV is positive.

Example 1.
The SM Company, which has a Rs 20 million, 12 percent annual coupon and
outstanding with 10 years remaining to maturity. This issue, which was sold five
years ago, had flotation cost of Rs 1.2 million that the firm has been amortizing a
straight-line basis over the 15- year original life of the issues. The bond has a call
provision that permits the company to retire the issue by calling in the bonds at 5
percent call premium.
Investment bankers have assured SM Company that it could issue an additional
Rs 20 million of new 10 percent coupon, 10-year bonds that pay interest
annually. Flotation costs on new issue will amount to Rs 1 million. To ensure that
the fund required to pay off the old debt will be available, the new bonds will be
sold on one month before the old issue is called, so for one month, interest will
have to be paid on two issues. Current short-term interest rates are 6 percent.
Predictions are that long-term interest rates are unlikely to fall below 10 percent.
Corporate tax rate is 40 percent, should the company refund the existing bond?
Example 1. Solve
Given Old issue New issue
Face value Rs. 20 million Rs. 20 million
Coupon rate 12 % 10 %
Original maturity 15 years 10 years
Remaining maturity 10 years 10 years
Flotation costs Rs. 1.2 million Rs. 1 million
Call premium 5% NA

Overlap period 1 month

Short term interest rate 6 %
Tax rate 40 %
Example 1.
THANK YOU