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    Bond-refunding problem and capital budgeting

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    Explain how the bond-refunding problem is similar to a capital budgeting decision?

    If common stockholders are the owners of the company, why do they have the last claim on assets and residual claim on income?

    As an investor which type of security would you prefer to own and why?

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    Solution Preview

    Explain how the bond-refunding problem is similar to a capital budgeting decision?

    The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.
    The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.
    Decisions like the change in the methods of sales distribution, or an advertisement campaign or research and development programs have long-term implications for the firm's expenditures and benefits, and therefore, they should also be evaluated as investment decisions. Several different procedures are available to analyze potential business investments.
    Corporate bonds are securities whose features are spelled out in their indenture agreement.
    Bond refunding analysis is similar to capital budgeting analysis.

    We can conceptualize bond refunding analysis as involving 4 steps:

    1. Determine the Investment Outlay Required to Refund the Issue.

    2. Calculate the Annual Flotation Cost Tax Effects

    3. Calculate the Annual Interest Savings

    4. Calculate the NPV of the refunding decision using the above information.

    Suppose that interest rates might fall further, should we refund now or later. To address this question, one must compute the expected NPV of refunding. ...

    Solution Summary

    This explains the bond-refunding problem and its similarity to a capital budgeting decision

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