Refunding Discounted Debt: A Clarifying Analysis

Shareholder gains from callable‐bond refundings

“…The most likely explanation, however, is market imperfectionsspecifically, taxes and transactions costs-that may render the perfect market decision rule not strictly applicable in practice. Much of the recent literature on bond refunding has in fact attempted to incorporate transactions costs and tax effects into the measurement of the benefit from a call (Boyce and Kalotay, 1979a,b;Emery and Lewellen, 1984;Finnerty, 1986;Lewellen and Emery, 1981;Livingston, 1980;Ofer and Taggart, 1977;Yawitz and Anderson, 1977), but in none of those analyses has an allowance for the remaining-time-to-maturity option value that may be extinguished by a call been made.' The derived benefit measures are therefore incomplete.…”

“…Frequent attention has been paid in the finance literature to the valuation gain that can be realized for shareholders when a firm calls, for retirement and refunding, an existing nonconvertible debt issue (Bowlin, 1966;Boyce and Kalotay, 1979a;Brick and Wallingford, 1985;Emery and Lewellen, 1984;Finnerty, 1986;Lewellen and Emery, 1981;Livingston, 1980;Ofer and Taggart, 1977;Pye, 1966;Yawitz and Anderson, 1977). The central principle that has emerged from these analyses is the concept of 'parity' in the firm's future financial obligations as the key to a proper assessment of the refunding gain (Franks and Hodges, 1978;Lewellen and Emery, 1981;Ofer and Taggart, 1977;Yawitz and Anderson, 1977).…”

Refunding Noncallable Debt

“…Most of that literature has concentrated on the question of how to measure the benefit to a company's shareholders of exercising the call provision associated with an outstanding debt issue (see [3], [12], [21], [26], [27], [29], and [31]). Among the related concerns have been the matters of whether there are valuation advantages to the deliberate issuance of discount-including "zero coupon"-bonds (see [9], [22], and [28]), and whether there can be profitable opportunities for refunding prior to maturity debt instruments that were issued at par but later trade at a discount (see [1], [2], [13], [15], [17], [18], and [23]).…”

“…Attention has, of course, been given to the question of whether it can be worthwhile from the standpoint of shareholders for the firm to refund "normal" coupon-bearing debt that trades at a discount from its issue price due to an increase in interest rates (see [1], [2], [13], [15], [17], [18], and [23]). In that circumstance, the refunding would be accomplished by repurchasing the bonds at their market price.…”

“…The potential problem is that a gain equal to the difference between the original issue price of the bonds and their lower repurchase price would typically have to be recognized for tax purposes. In a recent paper, however, Finnerty [13] outlines a possible strategy for avoiding this liability.…”