Valuing Bonds

The value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. Yield to maturity is the discount rate at which the sum of all future cash flows from the bond is equal to the price of the bond. "Time to maturity" refers to the length of time before the par value of a bond must be returned to the bondholder. This section will show you how to calculate a bond's yield to maturity and calculate the price of a bond.

Deciding to Refund Bonds

Refunding occurs when an entity that has issued callable bonds calls those debt securities to issue new debt at a lower coupon rate.

LEARNING OBJECTIVE

  • Determine when to refund a debt issue

KEY POINTS

    • The issue of new, lower-interest debt allows the company to prematurely refund the older, higher-interest debt.
    • Bond refunding occurs when a) interest rates in the market are sufficiently less than the coupon rate on the old bond, b) the price of the old bond is less than par. and c) the sinking fund has accumulated enough money to retire the bond issue.
    • The decision of whether to refund a particular debt issue is usually based on a capital budgeting (present value) analysis.

TERM

  • sinking fund

    A sinking fund is a fund established by a government agency or business for the purpose of reducing debt by repaying or purchasing outstanding loans and securities held against the entity. It helps keep the borrower liquid so it can repay the bondholder.

Refunding occurs when an entity that has issued callable bonds calls those debt securities from the debt holders with the express purpose of reissuing new debt at a lower coupon rate. In essence, the issue of new, lower-interest debt allows the company to prematurely refund the older, higher-interest debt. On the contrary, nonrefundable bonds may be callable, but they cannot be re-issued with a lower coupon rate (i.e., they cannot be refunded).

The decision of whether to refund a particular debt issue is usually based on a capital budgeting (present value) analysis. The principal benefit, or cash inflow, is the present value of the after-tax interest savings over the life of the issue.

Bond refunding occurs when all three of the following are true

  1. Interest rates in the market are sufficiently less than the coupon rate on the old bond
  2. The price of the old bond is less than par
  3. The sinking fund has accumulated enough money to retire the bond issue.

The three steps of whether to make a refunding decision are as follows:

Step 1: Calculate the present value of interest savings (cash inflows):

Interest savings = annual interest of old issue - annual interest of new issue

Step 2: Calculate the net investment (net cash outflow at time 0). This involves computing the after-tax call premium, the issuance cost of the new issue, the issuance cost of the old issue, and the overlapping interest. The call premium is a cash outflow.

Step 3: Finally, calculate the net present value of refunding.

Net present value of refunding = Present value of interest savings - Present value of net investment