The Bond Refunding Decision as a Markov Process

Abstract

Corporations that issue long-term debt are frequently faced with the opportunity to call the bonds and issue new bonds at more advantageous interest rates. When the current interest rate falls below the contractual interest rate on the outstanding debt, then computations must be made to evaluate the desirability of the refunding decision. This paper investigates the possibility of introducing the probabilities of different interest rates in the future, thus considering the desirability of postponing the refunding as well as the desirability of refunding now. There are four basic steps in the analysis of the decision whether or not to refund a currently outstanding bond issue prior to its maturity date.These steps are: a. the computation of the relevant cash flows (or the relevant costs), b. the choice of the rate of discount to be used in making the analysis, c. the treatment of uncertainty, d. the incorporation of qualitative factors.