The Effect of Bond Refunding on Shareholder Wealth: Comment

Abstract

IN A RECENT PAPER, Yawitz and Anderson [3] concluded that bond should be evaluated as refundings, which are defined such that total interest payments of the firm do not change. For taking place after decline in interest rates, the par value of new debt must exceed that of old debt in order for this condition to hold. They feel [3] that a problem exists in evaluating nonpure transactions, for leverage effects may swamp the effects of on shareholder wealth if the amount of debt decreases. Their analysis seems to leave unclear how some nonpure refundings should be viewed. Yet, on practical level, managers appear to confront such cases. The recent action by AT&T to redeem about half of its outstanding issue of 8.75% debentures due in 2000 is vivid example, since new equity issue financed the transaction. Indeed, desire to reduce -the proportion of debt in the capital structure was specific objective associated with the decision [1]. Our purpose in this paper is to argue that the refunding condition is unnecessarily restrictive and to point out that the Yawitz-Anderson decision rules for both pure and mixed refundings are needlessly complex. Following Ofer and Taggart [2], we reiterate the notion that investment and financing decisions can be separated in decisions. Given the lack of operationally relevant knowledge concerning optimal capital structure, it is useful for managers to be able to assess the investment portion of the decision outside the penumbra produced by capital structure issues. Using Modigliani-Miller valuation model, Ofer and Taggart [2] show that will increaseshareholder wealth when'