Capital Structure, Call Policies and Flotation Costs: A Dog Chasing Its Tail (Revision of 12-95)

This paper presents a characterization of callable bond pricing and call decision when there are transactions costs. To keep capital structure constant a firm that has outstanding callable bonds refinances them with similarly structured callable bonds. Since refinancing is costly, firms will delay the call decision. Given that the firm’s cash flows differ from investors’ cash flows by transaction costs, the valuation of the callable bond will be different for the firm and for investors. We find that investors’ valuation function exhibits three important empirical regularities for low interest rates: Inverse convexity, negative duration and market (investors’) prices higher than call prices. In addition, for low interest rates, the market valuation of the bonds has a hump. We have assumed that the firm will replace the outstanding bond with an identically structured bond in order to simplify the problem of analyzing multiple refundings. The firm will be replacing a seasoned bond with a new one. It will therefore be pasting a pricing function with itself at two different times to expiration. We can say that the new issue is the head and the seasoned bond the tail because it is at the end of its life. Following this procedure we collapse into a single step the problem of figuring out when to replace a callable bond with another callable bond that needs to be priced before pricing the former. This exchange of bond will occur at a lower rate than the normal call rate when cash in hand is used. Small transaction costs will justify waiting past the call price if the firm wants to keep a callable bond in its capital structure. Replacing a callable bond with another callable bond also allows the analysis of multiple future refundings. We conclude that transaction costs alone may be enough to explain the overvaluation of callable bonds with respect to the call price. We use a general one-factor interest rate process in continuous time that nests most of the popular one-factor interest rate models used by researchers and practitioners. By comparing the refunding characteristics for two different alternatives we shed light into the problem of optimal capital structure. When refunding is costly, the indifference among funding sources disappears. Once an alternative source has been chosen, the firm is in a sense locked to that source because it is costly to change. The firm will therefore choose a capital structure that will minimize refunding costs. Transaction costs make capital structure irreversible, implying that capital structure matters.