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Refunding refers to the issuance of new securities for the purpose of retiring or replacing existing bonds or preferred stock. In simple terms, a company replaces its old financing with new financing when the new arrangement is expected to provide financial benefits.
The old securities may be retired either by exercising the call feature or by purchasing the securities from the open market.
- Market interest rates have declined.
- The company can obtain new financing at a lower cost.
- The existing securities contain unfavorable terms.
- The company wants to improve its capital structure.
- The company wants to change or extend the maturity period of its debt.
Suppose a company has issued bonds carrying an interest rate of 12%. Later, market interest rates fall to 8%. The company may issue new bonds at 8% and use the proceeds to retire the existing 12% bonds. This may reduce the overall financing cost of the company.
Refunding should be undertaken only when the present value of expected benefits from refunding exceeds the initial cost involved in the refunding process.
- Calculate the initial outlay required to retire the existing securities.
- Calculate the cost of issuing new securities.
- Estimate future savings in interest or financing costs.
- Determine the after-tax cash flow benefits.
- Discount the future benefits to their present value using the current after-tax market interest rate on debt.
- Compare the present value of benefits with the initial outlay.
If Present Value of Benefits > Initial Outlay
→ Refunding is Financially Desirable
Steps for Refunding Decision
Step 1: Calculation of Initial Outlay
| Item / Calculation | Flow Type |
|---|---|
| Call premium, net of tax Call premium rate × face value of old issue × (1 - T) |
Outflow |
| Flotation cost on the new issue Flotation cost rate × face value of new issue |
Outflow |
| Tax shield on unamortised portion of flotation cost of old issue issue cost (old)life (old) × remaining life × T |
Inflow |
| Interest during overlap period Face value of old × interest rate (old) × Overlap time12 × (1 - T) |
Outflow |
| Interest earned from investment from government securities Face value of old × reinvestment rate × Overlap time12 × (1 - T) |
Inflow |
Step 2: Calculation of Annual Cash Flows Saving
| Item / Calculation | Flow Type |
|---|---|
| Interest saving [different in interest × face value of old debt] (1 - T) |
Inflow |
| Tax shield of flotation cost of new issue flotation cost (new)life (new) × T |
Inflow |
| Tax shield lost on the flotation cost of old debt flotation cost (old)life (old) × T |
Outflow |
Step 3: Calculation of NPV of Refunding
= Annual cash flow × PVIFAkdt, n - Initial outlay
If the NPV of the refunding is positive, refunding should be made.
Before issuing bonds or preferred stock, a company must determine the major terms and conditions attached to the securities. These conditions determine the rights of investors and the obligations of the company.
Par value, also known as face value or nominal value, is the amount stated on the security certificate.
In the case of bonds, the par value represents the amount that the company promises to repay at maturity.
Preferred shareholders generally receive a fixed dividend at a specified rate. This dividend is usually paid before dividends are distributed to common shareholders.
Maturity refers to the date on which the principal amount of a bond becomes due for repayment.
Ordinary preferred stock generally does not have a fixed maturity date, although redeemable preferred shares may be repurchased after a specified period.
The cumulative feature is mainly associated with preferred stock. If a company is unable to pay dividends in a particular year, the unpaid dividend accumulates and may have to be paid in future years before any dividend is distributed to common shareholders.
Participating preferred shareholders receive their fixed dividend and may also receive an additional share in the company's earnings under certain conditions.
Common shareholders generally possess voting rights and participate in important decisions of the company. Preferred shareholders usually have limited voting rights, while bondholders generally do not have voting rights because they are creditors of the company.
First Priority
Second Priority
Residual Claim
A call feature gives the issuing company the right to redeem or retire securities before their maturity date or specified redemption date.
This feature is particularly useful when market interest rates decline and the company wishes to replace high-cost securities with lower-cost securities.
The conversion feature allows the holder of a security to convert it into another security, generally common stock.
- Convertible bonds may be converted into common shares.
- Convertible preferred shares may also be converted into common shares.
A sinking fund is established by a company for the gradual repayment of long-term debt.
The company periodically sets aside funds so that it can retire a portion of its debt over time instead of repaying the entire amount at maturity.
A hybrid security is a financial security that combines the characteristics of two or more financial instruments. It generally contains features of both debt and equity.
Interest / Fixed Return
Ownership / Growth Potential
A convertible bond is a bond that gives the holder the right to convert the bond into a specified number of common shares.
It contains a debt feature because the investor receives interest, and an equity feature because the investor can convert the bond into common shares.
Convertible preferred stock gives the holder the right to convert preferred shares into common shares.
The investor receives the benefits of preferred dividends and may later participate in the growth of the company by converting the shares into common stock.
Long-term financing refers to funds obtained by a company for a period generally exceeding one year. Such funds are commonly used for purchasing fixed assets, business expansion, modernization and other long-term investment purposes.
Common stock represents the ownership interest of shareholders in a company. Common shareholders are the real owners of the company and generally have voting rights.
They receive dividends after the claims of creditors and preferred shareholders have been satisfied.
- Represents ownership in the company.
- Generally provides voting rights.
- Dividend is not fixed.
- Dividend depends on profitability and dividend policy.
- Common shareholders have residual claims on income and assets.
- There is generally no maturity date.
Long-term debt refers to funds borrowed for a period generally exceeding one year. Bonds and debentures are common forms of long-term debt.
The company is required to pay interest periodically and repay the principal amount according to the terms of the debt agreement.
- Creates a fixed financial obligation.
- Interest is generally paid periodically.
- Principal is repaid at maturity.
- Debt holders are creditors rather than owners.
- Debt holders generally do not have voting rights.
- Interest may provide tax advantages.
Preferred stock is a type of ownership security that generally provides a fixed dividend and priority over common shareholders in the payment of dividends and claims on assets.
- Generally carries a fixed dividend.
- Has priority over common stock in receiving dividends.
- Has priority over common stock during liquidation.
- Usually has limited or no voting rights.
- May have cumulative features.
- May have participating or convertible features.
| Basis | Common Stock | Long-Term Debt | Preferred Stock |
|---|---|---|---|
| Nature | Ownership Capital | Borrowed Capital | Ownership Security |
| Return | Variable Dividend | Fixed Interest | Generally Fixed Dividend |
| Voting Rights | Generally Available | Generally Not Available | Usually Limited |
| Maturity | No Fixed Maturity | Fixed Maturity | Generally No Fixed Maturity |
| Claim on Assets | Residual Claim | First Priority | Priority Over Common Stock |
| Financial Risk | Low Fixed Obligation | Higher Due to Fixed Payments | Moderate |
Conclusion
The selection of an appropriate source of long-term financing depends upon factors such as cost of capital, financial risk, control considerations and the financing requirements of the company.
Common stock provides permanent ownership capital, long-term debt provides borrowed funds with a fixed financial obligation, and preferred stock provides characteristics that lie between debt and common equity.
Similarly, refunding and hybrid securities provide companies with additional flexibility in managing their financing cost and capital structure.
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