1. ©2012 McGraw-Hill Ryerson Limited 1 of 35 Learning Objectives 1.Identify and describe the key features of long-term debt. (LO1) 2.Differentiate bond yields and prices as influenced by how corporations and governments are rated by bond rating services. (LO2) 3.Analyze the decision of whether or not to call in and reissue debt (refund the obligation) when interest rates have declined. (LO3)

2. ©2012 McGraw-Hill Ryerson Limited 2 of 35 The Refunding Decision When market interest rates decline, selling new low coupon rate bonds to buy back the existing high coupon rate bonds is called a refunding operation. To refund a bond, the bond indenture agreement should include a call provision. The refunding decision is analyzed as a capital budgeting problem. The goal is to see whether savings in interest costs exceed financing costs related to redeeming and reissuing bonds. LO3

3. ©2012 McGraw-Hill Ryerson Limited 3 of 35 A Refunding Decision Example: LO3 Old IssueNew Issue Size……………………………………… …… $10,000,00 0 Interest rate………………………………….. 10.5%8% Total life………………………………………. 25 years20 years Remaining life……………………………….. 20 years Call premium………………………………… 10%--- Underwriting costs………………………….. $125,000$200,000 Other issue costs……………………………. 25,00030,000 Overlap period………………………………. 1 month Short-term yield……………………………... 3.5% Tax bracket…………………….………..25% Discount rate…………………………….6%: 8% (1-.20) Aftertax borrowing rate for new issue

4. ©2012 McGraw-Hill Ryerson Limited 4 of 35 Costs (Outflows) Benefits (Inflows) 1. Net cost of call 4.Cost savings in lower premium... ($1,000,000)interest rates $2,150,610 2.Net cost of borrowing expenses on new issue (181,558) 3. Duplicate interest during overlap period... (43,750) Present value of costs ($1,225,308) Present value of benefits $2,150,610 Net present value....$925,302 The refunding decision: Step C—Net Present Value LO3