Refinancing Law and Legal Definition
Refinancing is the refunding or restructuring of debt with new debt, equity, or a combination of these. Businesses refinance their debts when interest rates drop. Since this tends to happen in times when money is readily available from banks or other sources of lending, the business can lower its overall costs of financing by reworking its loan portfolio. Sometimes refinancing involves the issuance of equity in order to decrease the proportion of debt in the borrower's capital structure. As a result of refinancing, the maturity of the debt may be extended or reduced, or the new debt may carry a lower interest rate, or some combination of these options.
Refinancing may be done by any issuer of debt, such as corporations and governmental bodies, as well as holders of real estate, including home owners. When a borrower retires a debt issue, the payment is made in cash and no new security takes the place of the one being paid off. The term "refunding" is used when a borrower issues new debt to refinance an existing one.
CORPORATE OR GOVERNMENT DEBT REFINANCING
The most common incentive for corporations or governmental bodies to refinance their outstanding debt is to take advantage of a decline in interest rates from the time when the original debt was issued. Another trigger for corporate debt refinancing is when the price of a company's common stock reaches a level which makes it attractive for a firm to replace its outstanding debt with equity. Aside from reducing interest costs, this latter move gives a firm additional flexibility for future financing; by retiring debt the firm will have some unused debt capacity. Regardless of the reason for the refinancing, the issuer has to deal with two decisions: 1) Is the time right to refinance, and 2) What type of security should be issued to replace the one being refinanced?
If a corporation or governmental body wishes to refinance before the maturity date of the outstanding issue, they will need to exercise the call provision of the debt. The call provision gives the borrower the right to retire outstanding bonds at a stipulated price, usually at a premium over face amount, but never less than face value. The specific price which an issuer will need to pay for a call appears in the bond's indenture. The existence of a call premium is designed to compensate the bond holder for the firm's right to pay off the debt earlier than the holder expected. Many bond issues have a deferred call, which means the firm cannot call in the bond until the expiration of the deferment period, usually between five and ten years.
The cash outlay required by exercising the call provision includes payment to the holder of the bond for any interest which has accrued to the date of the call, and the call price, including premium (if any). In addition, the firm will need to pay a variety of administrative costs, including a fee to the bond's trustee. Of course, there will also be flotation costs for any new debt or equity that is issued as part of the refinancing.
Sometimes an issuer may be prohibited from calling in the bonds (e.g., during the deferred call period). In these instances, the issuer always has the opportunity to purchase its bonds on the open market. This strategy may also be advantageous if the outstanding bond is selling in the market at a price lower than the call price. Open market purchases involve few administrative costs. The corporation will recognize a gain on the repurchase if the market value is below the amount at which the corporation is carrying the bonds on its books (face value plus or minus unamortized premium or discount), or a loss on the repurchase if the market value is above the book value.
The major difficulty with open market purchases to effect a refinancing is that typically the market for bonds is "thin." This means that a relatively small percentage of an entire issue may be available on the market over any period of time. As a result, if a firm is intent on refinancing a bond issue, it almost always needs to resort to a call. This is why virtually every new bond that is issued contains a call provision. If an outstanding issue does not permit a call, another option available to the issuer is to seek tenders (offers to sell at a predetermined price) from current bond holders.
The new debt instrument issued in refinancing can be simple or complex. A corporation could replace an existing bond with traditional bonds, serial bonds (which have various maturity dates), zero-coupon bonds (which have no periodic interest payments), or corporate shares (which have no maturity date, but which may have associated dividend payments). One factor that a firm needs to consider is that the administrative and flotation costs of issuing either common or preferred shares are higher than for new debt. Furthermore, dividend payments, if any, are not tax deductible.
The decision to refinance is a very practical matter involving time and money. Over time the opportunity to refinance varies with changing interest rates and economic conditions. When a corporation anticipates an advantageous interest rate climate, it then analyzes the cash flows associated with the refinancing. Calculating the present value of all the cash outflows and the interest savings assists in comparing refinancing alternatives that have different maturity dates and capitalization schemes.
MORTGAGE REFINANCING
Owners of residential or commercial real estate use a similar method to analyze their refinancing decisions. In residential real estate the conventional wisdom applies the "2-2-2 rule": if interest rates have fallen two points below the existing mortgage, if the owner has already paid two years of the mortgage, and if the owner plans to live in the house another two years, then refinancing is feasible. However, this approach ignores the present value of the related cash flows and the effects of the tax deductibility of interest expense and any related points.
Therefore, a better analysis of a mortgage refinancing decision should be conducted as follows: 1) Calculate the present value of the after-tax cash flows of the existing mortgage; 2) Calculate the present value of the after-tax cash flows of the proposed mortgage; 3) Compare the outcomes and select the alternative with the lower present value. The interest rate to be used in steps one and two is the after-tax interest cost of the proposed mortgage.
BIBLIOGRAPHY
"Debt Restructuring." Investopedia.com. Available from http://www.investopedia.com/terms/d/debtrestructuring.asp. Retrieved on 18 May 2006.
Fabozzi, Frank J. Handbook of Mortgage Backed Securities. McGraw-Hill, 2001.
Jordahl, Eric, and Kevin T. Ponton. "Synthetic Refunding: A financial tool for a low interest-rate environment." Healthcare Financial Management. May 2003.
Schaub, John W. Building Wealth One House at a Time: Making it Big on Little Deals. McGraw Hill, 2005.
Walter, Robert. Financing Your Small Business. Barron's Educational Series, 2004.
Hillstrom, Northern Lights
updated by Magee, ECDI
