Net Present Value
We now compare our outflows and our inflows from the prior pages.
The refunding decision has a positive net present value, suggesting that interest rates have dropped to a sufficiently low level to indicate refunding is in order. The only question is: Will interest rates go lower—indicating an even better time for refunding? There is no easy answer. Conditions in the financial markets must be carefully considered.
A number of other factors could be plugged into the problem. For example, there could be overlapping time periods in the refunding procedure when both issues are outstanding and the firm is paying double interest (hopefully for less than a month). The dollar amount in these cases, however, tends to be small and is not included in the analysis.
In working problems, you should have minimum difficulty if you follow the four suggested calculations on the prior pages. In each of the four calculations we had the following tax implications:
1. Payment of call premium—the cost equals the amount times (1 − Tax rate) for this cash tax-deductible expense.
2. Underwriting costs on new issue—we pay an amount now and then amortize it over the life of the bond for tax purposes. This subsequent amortization is similar to depreciation and represents a noncash write-off of a tax-deductible expense. The tax saving from the amortization is equal to the amount times the tax rate.
3. Cost savings in lower interest rates—cost savings are like any form of income, and we will retain the cost savings times (1 − Tax rate).
4. Underwriting cost on old issue—once again, the writing off of underwriting costs represents a noncash write-off of a tax-deductible expense. The tax savings from the amortization are equal to the amount times the tax rate.
Other Forms of Bond Financing
As interest rates continued to show increasing volatility in the 1980s and early 1990s, two innovative forms of bond financing became very popular and remain so today. We shall examine the zero-coupon rate bond and the floating rate bond.
The zero-coupon rate bond, or zero-coupon bond, as the name implies, does not pay interest. It is, however, sold at a deep discount from face value. The return to the investor is the difference between the investor’s cost and the face value received at the end of the life of the bond. From an investor’s point of view, an advantage of the zero coupon bond is that there are no coupons to reinvest and the yield to maturity on the bond is locked in for the life of the bond. A dramatic case of a zero-coupon bond was an issue offered by PepsiCo Inc. in 1982, in which the maturities ranged from 6 to 30 years. The 30-year $1,000 par value issue could be purchased for $26.43, providing a yield of approximately 12.75 percent. The purchase price per bond of $26.43 represented only 2.643 percent of the par value. A million dollars worth of these 30-year bonds could be initially purchased for a mere $26,430.
The advantage to the corporation is that there is immediate cash inflow to the firm, without any outflow until the bonds mature. Furthermore, the difference between the initial bond price and the maturity value may be amortized for tax purposes by the corporation over the life of the bond. This means the corporation will be taking annual deductions without current cash outflow.
From the investor’s viewpoint, the zero-coupon bonds allow him or her to lock in a multiplier of the initial investment. For example, investors may know they will get three times their investment after a specified number of years. The major drawback is that the annual increase in the value of bonds is taxable as ordinary income as it accrues, even though the bondholder does not get any cash flow until maturity. For this reason most investors in zero-coupon rate bonds have tax-exempt or tax-deferred status (pension funds, foundations, charitable organizations, individual retirement accounts, and the like).
The prices of the bonds tend to be highly volatile because of changes in interest rates. Even though the bonds provide no annual interest payment, there is still an initial yield to maturity that may prove to be too high or too low with changes in the marketplace.
The bonds listed in Table 16-4 are examples of zero-coupon bonds. The bonds sell at a considerable discount from par value of $1,000 since they all have some time remaining until maturity.
Table 16-4 Zero-coupon bonds
Source: Bloomberg, March 2015.
Another interesting type of bond issue is the floating rate bond (long popular in European capital markets). In this case, instead of a change in the price of the bond, the interest rate paid on the bond changes with market conditions (usually monthly or quarterly). Thus, a bond that was initially issued to pay 9 percent may lower the interest payments to 6 percent during some years and raise them to 12 percent in others. The interest rate is usually tied to some overall market rate, such as the yield on Treasury bonds (perhaps 120 percent of the going yield on long-term Treasury bonds).
The price of a floating rate bond stays close to the $1,000 par value since the coupon adjusts with changes in market rates. The advantage to investors in floating rate bonds is that they have a constant (or almost constant) market value for the security, even though interest rates vary. An exception is that floating rate bonds often have broad limits that interest payments cannot exceed. For example, the interest rate on a 6 percent initial offering may not be allowed to go over 10 percent or below 3 percent. If long-term interest rates dictated an interest payment of 12 percent, the payment would still remain at 10 percent. This could cause some short-term loss in market value. To date, floating rate bonds have been relatively free of this problem. From an investor’s point of view, the best time to own floating rate bonds is when interest rates are expected to rise.
Zero-coupon rate bonds and floating rate bonds still represent a relatively small percentage of the total market of new debt offerings. Nevertheless, they should be part of a basic understanding of long-term debt instruments.
Advantages and Disadvantages of Debt
The financial manager must consider whether debt will contribute to or detract from the firm’s operations. In certain industries, such as airlines, very heavy debt utilization is a way of life, whereas in other industries (drugs, photographic equipment) reliance is placed on other forms of capital.