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The Case for Indexing a Bond's Call Price Author(s): Douglas R. Emery, J. Ronald Hoffmeister and Ronald W. Spahr Source: Financial Management, Vol. 16, No. 3 (Autumn, 1987), pp. 57-64 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665981 . Accessed: 12/06/2014 21:36 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. . Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserve and extend access to Financial Management. http://www.jstor.org This content downloaded from 185.2.32.21 on Thu, 12 Jun 2014 21:36:21 PM All use subject to JSTOR Terms and Conditions

The Case for Indexing a Bond's Call Price

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The Case for Indexing a Bond's Call PriceAuthor(s): Douglas R. Emery, J. Ronald Hoffmeister and Ronald W. SpahrSource: Financial Management, Vol. 16, No. 3 (Autumn, 1987), pp. 57-64Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665981 .

Accessed: 12/06/2014 21:36

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserveand extend access to Financial Management.

http://www.jstor.org

This content downloaded from 185.2.32.21 on Thu, 12 Jun 2014 21:36:21 PMAll use subject to JSTOR Terms and Conditions

The Case for Indexing a Bond's Call Price

Douglas R. Emery, J. Ronald Hoffmeister, and Ronald W. Spahr

Douglas R. Emery is a member of the faculty at the University of Missouri, Columbia. J. Ronald Hoffmeister is a member of the faculty at Arizona State University, Tempe. Ronald W. Spahr is a member of the faculty at the University of Wyoming, Laramie; for the academic year 1987-88, Professor Spahr is visiting the Federal Home Loan Bank Board, Washington, D.C. Support from the Center for Financial System Research at Arizona State University is gratefully acknowledged.

I. Introduction The purpose of this paper is to consider an alterna-

tive to the standard call provision contained in most corporate debt. The alternative is to make the debt callable at its after-tax value to the bondholder. This is referred to as an "indexed call provision," since a sim- ple method of creating such an instrument in practice is to index the call price to market-traded securities such as government securities of comparable maturity.

In comparison with the usual fixed-price call provi- sion, the indexed call provision is particularly attrac- tive to the firm because of greater refunding flexibility. This greater flexibility is due, first, to the lower cost and complexity of refunding discounted debt and, sec- ond, to eliminating the need for a "no call period." Another advantage of the indexed call provision is that it is costly to the firm only if it actually exercises the call option. We also show that, in addition to these benefits, the indexed call provision affords all the benefits that have been attributed to the usual fixed- price call provision.

II. The Benefits of the Call Provision Consider first the benefits that have been attributed

to standard call provisions. Taxes have been proposed as a potential explanation for the call provision in cor- porate debt by [3, 5, 11, and 15], among others. Re- cently, however, it has been shown that it is not neces- sary to have a call provision in order to obtain tax benefits from refunding debt [7]. Further, Brick and Wallingford [4] conclude that a provision whose call price is equal to the bond's market price offers larger tax benefits than the standard fixed call price provision.

Other explanations for the existence of a call provi- sion in corporate debt include (i) the resolution of certain agency problems by retaining exclusive stock- holder benefit from "growth opportunities" [2], (ii) the reduction of agency costs arising from other sources [1, 14], and (iii) the reduction of transaction costs [8]. Assuming stochastic interest rates, refunding can be attractive to firms with outstanding debt, whether or not the debt is callable. Given a likelihood that refund- ing will be undertaken, the call provision eliminates brokerage fees and search costs, as well as any need to offer a premium to induce bondholders to surrender their securities.

The authors thank Brad Jordan, Chris Prestigiacomo, Rick Smith, an anonymous referee, and, especially, Robert Taggart for helpful com- ments on earlier drafts of this paper.

57

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58 FINANCIAL MANAGEMENT/AUTUMN 1987

A reason cited by some corporate executives for including a call provision is flexibility. Apparently, their concern is that an outstanding debt issue might restrict the corporation from taking certain desirable actions at some point in the future. On that score, the inclusion of a call provision can significantly cut one other potentially major cost: the elimination of "hold- outs." If the only purpose in refunding is to reduce interest costs, then bonds that can be purchased profit- ably in the market can be refunded, while leaving the remaining bonds outstanding [7]. However, to elimi- nate an indenture, the firm must purchhse every bond that is outstanding. This can be a difficult and costly undertaking because market prices represent the "mar- ginal investor." This notion is, of course, the reason underlying tender offers such as those by AT&T in the late 1970s: The purchaser offers a premium in order to attract more of the securityholders. Unfortunately, in spite of a premium offered, "holdouts" might refuse to sell their securities in the hope of expropriating the net present value of any corporate decision the indenture provision prohibits.

The importance to the firm of these "non-quanti- fied" benefits of the call option can be inferred from empirical evidence. Thatcher [14] points out the com- mon use of an option that allows the firm to call the debt during the "no call" period for purposes other than refunding at a lower interest rate. The stated motiva- tion is to maintain the firm's decision-making flexibil- ity. Based on whether or not firms use such an option, Thatcher [14] provides evidence of the existence of agency costs hypothesized by Bodie and Taggart [2] and Myers [12].

We have enumerated some of the potential reasons why corporations include call provisions in bond in- dentures and we have cited supporting evidence. Other reasons may also exist. Our premise throughout the rest of the paper is that a call provision is valuable and/or necessary. The purpose of the paper is not to address the question of whether a call provision should be included in an indenture but, rather, to propose an alternativeform to use for a call provision and detail its advantages.

III. A Costless Call Option When a callable bond is issued, the bondholder buys

the bond and sells the firm an option to repurchase the bond at a fixed price for the life of the security. The value of a callable bond,

B0', can therefore be repre-

sented as the value of a non-callable bond, B0, minus the value of the firm's call option, Co':

B0' = B0 - Co'. (1)

Ordinarily, the call option is neither worthless to the corporation nor costless to the bondholder. However, by indexing the call price to market interest rates, what we propose is to create a call option that is valuable to the firm, yet costs the firm nothing.

In an efficient market with no taxes, a firm's option to retire a bond by paying the bondholder the current market value of the bond is costless to the bondholder. The equilibrium market value of such an option is zero. However, with taxes, the option is not costless to the bondholder and bondholders will require payment to cover changes in their tax liability in exchange for granting the firm the option to call the bond at its market price.

In the case of debt selling at a premium (above par), for example, a call alters the bondholder's tax liability in two ways. First, the bondholder is "forced" to rec- ognize a gain. Second, when the bondholder re-invests the proceeds received from the corporation, the taxes on the bondholder's interest income are altered. In the next section we show that by having an indexed call provision we can remove the costs borne by the bond- holder and retain the benefits for the firm.

IV. An Indexed Call Provision The call price for the zero cost option proposed

heretofore depends on the bondholders' tax liability, part of which is determined by the long-term capital gains tax rate, denoted here by tg. When a firm calls a bond issue, a bondholder receives the face value of the bond, B0, plus a call premium, P, and pays taxes of tP on the call premium. The net amount received by the bondholder, then, is

Bo + P(1 - t,). (2)

To be indifferent to having the bond called, the bond- holder must be equally well-off, whether or not the bond is called. Thus, it must be possible for the bond- holder to re-invest the after-tax proceeds from the call so as to receive exactly the same after-tax cash flows that would have been received if the bond had not been called. The importance of maintaining identical after- tax cash flows for the proper assessment of corporate decisions has been shown by Lewellen and Emery [10]. By insuring identical bondholder after-tax cash flows, parity for the bondholder is maintained.

Let r0 represent the before-tax coupon rate on a call- able bond,

B0 the bond's par value, and T the bond-

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EMERY, HOFFMEISTER, AND SPAHR/INDEXING A BOND'S CALL PRICE 59

holders' ordinary income tax rate.' At time period j bondholders would receive after-tax cash flows of

r0B0(1 - T) every period for the next (n - j) periods plus BO at maturity in period n if the bonds were not called. To create an identical set of after-tax cash flows when the bonds are called, bondholders can invest the after-tax call premium, P(1 - tg),

in the form of an installment loan. The loan is configured so that its after-tax payments of principal and interest make up any cash flow short-fall that would occur without them. This is similar to the application of adjusted present value [13] to bond refunding [9, 10].

The indexed call price is designed to insure that the bondholder will receive the same yield and cash flow pattern whether or not (or, however often) the bond is called.2 When the bond is called, the bondholder re- invests an amount equal to the par value of the original bond at the prevailing market rate of interest on identi- cal-risk balloon debt. The remaining after-tax pro- ceeds received from the corporation are reinvested in an installment debt contract at the prevailing rate for new installment debt of like risk. For convenience, we assume the rates on the balloon debt and installment debt are identical.

When the bond is called, the bondholder must re- ceive after-tax proceeds such that, after re-investment, the cash flow pattern that would have occurred without the call is retained. Assuming the bond has been held sufficiently long for the gain to qualify for capital gain tax treatment, the total after-tax proceeds are given by Equation (2). If the bond is called in period j, the after- tax proceeds from the call premium are denoted Sj, and are given as

Sj = P(1 - td). (3)

If the bond were not called in period j, the bondhold- er would receive after-tax cash flows of r0B0(1 - T) in each of the remaining (n -j) periods, where n is the original life of the bond, and a balloon payment of BO at maturity, (n -j) periods from now. T is the bondhold- er's ordinary income tax rate and ro is the original coupon rate. To reproduce these after-tax cash flows if

the bond is called, it must be the case that

roBo(1 - T)= (1 - T)r(Bo + Sj,)+ (Sj+t, -

Sj+t+1), (4) t = 0,1,2,...,n-j;

and

Sn = 0, (5)

where Sj,+ is the "excess principal" (above the original par value) invested in period j + t and r is the required interest rate on both noncallable and indexed call price debt at j, the time the bond is called. By requiring that Sj be invested in installment debt and

Sn be equal to

zero, the balloon payment in period n is identical whether or not the bond is called. Equations (4) and (5) insure that the annuity of after-tax cash flows in peri- ods j + 1 through n are also identical whether or not the bond is called.

Solving Equation (4) for Sj+t, we have

(r0 - r)B0(1 - T) + Sj+,,+( Sj +t (6) [1 + (1 -T)r]

and solving Equations (5) and (6) recursively for Sj,

n-j (r0 - r)B0(1 - T) Sj= (7)

t= 1 [1 + (1 - T)r]t

Putting this result into Equation (3), the call premium must be

Sj n-j (r0-r)B0(1-T) n -

=.

(8) (1-tg) t= 1 (1 - t,)[l + (1 - T)r]t

The indexed call price then is the call premium plus the par value, or

n-j (ro - r)Bo(l - T) Call Price = Bo + 1 . (9)

t= 1 (1 - t,)[1 + (1 - T)r]t

The market price, Bj, of the bond just prior to calling is

B0 n-j

roBo B o=

+ o

. (10)

(1 +r)n-j t=l (1 +r)t

Since, at time period j, Bo can be expressed as

Bo n-j rB

B0 =

+n--- ,

(11) (1 +r)n-j t=l (1 +r)'

'For convenience, it is assumed that all bonds have a par value that is equal to their market value at the time of issue. Thus, ro is the market required return on the bond at the time of its issue.

2The call options we describe here are theoretical constructs based on a single bondholder. Because tax rates and transaction costs are not uni- form across all bondholders (among other reasons), such an instrument would not be identical for all bondholders and thus, the bond's price behavior is an empirical question.

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60 FINANCIAL MANAGEMENT/AUTUMN 1987

it is easily shown that if both ordinary and capital gains tax rates for investors are zero, then the call price given in Equation (9) equals the market price given in (10).

V. Using the Indexed Call Provision The indexed call provision is derived above for pre-

mium debt with differential capital gains and regular tax rates. However, there are two additional consider- ations concerning the use of the indexed call provision. First, the tax rate differential has been eliminated by recently enacted legislation. Second, the indexed call price function for discounted debt differs from the function for premium debt because of the tax-timing option connected with bond ownership [6]. In this sec- tion, the indexed call price functions for premium and discount debt under the current tax code are specified and a numerical example of the use of each is given.

A. The Tax Reform Act of 1986 The Tax Reform Act of 1986, recently passed by

Congress, does away with the differential between the rates tg and T. With this change Equation (9) can be reduced to

n-j (r0 - r)Bo Call Price = B + ( - (9a)

t= 1 [1 + ( 1-T)r]t

It is easily shown that, for T > 0, the call price given by Equation (9a) is always greater than the market price given by Equation (10). Thus, under the Tax Reform Act of 1986, a call price equal to the bond's market value, like the one specified in [4], creates a call option that is costly to taxable investors. Under this new law, only investors with a zero tax rate would be indifferent to a call price equal to the bond's market value. There- fore, the indexed call price exceeds the bond's market value, the excess amount being, in effect, a transaction cost.

B. The Indexed Call Price for Discounted Debt

In the case of premium debt the firm must compen- sate the investor for the increased tax liability that would not otherwise be incurred if the bond were not called. So in Equation (8), to maintain bondholder indifference, the premium is "grossed up" to cover this tax liability. With the sign reversed for discounted debt, Equations (8) and (9) have the firm capturing the tax credit. However, a holder of a bond (with or with- out a call provision attached) can claim the tax benefit from a loss at any time by simply selling the bond and

Exhibit 1. Reinvested After-Tax Cash Flows if the Bond Is Selling Above Par t = 1 2 3 Par Bond Income

(0.08)(1000)(1 -0.3) $56.00 $56.00 $56.00 Installment Debt Interest

Income (0.08)(Previous Balance)(1-0.3) 2.11 1.45 0.74

Installment Debt Principal Payment 11.89 12.55 13.26

Remaining Installment Debt Balance ($37.70 at t= 0) 25.81 13.26 0.00

Par Bond Principal 1000.00

Total After-Tax Cash Flows 70.00 70.00 1070.00

repurchasing an equivalent security. Therefore, inves- tors will not be indifferent to the indexed call provision if Equation (9) is used for discounted debt since it would reduce their tax savings on a loss. With dis- counted debt, in other words, investors will not be indifferent between indexed call provision debt and noncallable debt if the firm can expropriate this tax credit with the indexed call provision. With Equation (9), noncallable debt would be more valuable than indexed call provision debt since investors could cap- ture that tax credit for themselves if the bond had no call provision. This tax asymmetry between premium and discount debt (defer gains and recognize losses) is the investor's tax-timing option connected with bond trading [6].

To maintain bondholder indifference Equation (9) becomes

Call Price = Bo

+ (ro -

r)Bo(1- , (9b) t= 1 [1 + (1 -T)r]'

for discounted debt. Note that this call price is appro- priate under both the previous tax code and the Tax Reform Act of 1986.

C. A Numerical Example of Premium Debt As an illustration, suppose a bond was issued with

an indexed call price given by Equation (9a), a coupon rate of ro = 10% per period, a par value of $1000, and the bond has three more periods until maturity. Sup- pose, further, that the current required rate on both amortized and unamortized debt, as indexed to a gov- ernment yield curve, is r = 8%. Thus, the current mar- ket value of the bond, if a call option were not at- tached, is specified by Equation (10) as $1051.54. If the tax rates are T = 0.3 on both regular income and

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EMERY, HOFFMEISTER, AND SPAHR/INDEXING A BOND'S CALL PRICE 61

Exhibit 2. Reinvested After-Tax Cash Flows if the Bond Is Selling Below Par t= 1 2 3 Par Bond Income

(0.12)(964.18)(1 - 0.3) $80.99 $80.99 $80.99 Interest on Reinvested Income

(0.12)(Previous Balance)(1 -0.3) 0.00 0.92 1.93

Reinvested Income - 10.99 -10.99 Accumulated Reinvestment

($0 at t= 0) 10.99 22.90 24.83 Withdrawal of Accumulation + 24.83

Par Bond Principal 964.18

Total After-Tax Cash Flows 70.00 70.00 1070.00

long-term capital gains income, then, from Equation (9a), the call price is currently equal to $1053.86.

If the bond is not called the bondholder will receive after-tax cash flows of $70, $70, $1070, at t = 1, 2, and 3, respectively. If the bond is called by the firm, the bondholder will receive $1053.86 and pay taxes of $16.16, for a net amount of $1037.70. Exhibit 1 shows that if the bondholder invests $1000 in an 8% par value bond and the remaining $37.70 in installment debt at 8%, the bondholder will receive identical after-tax cash flows of $70, $70, $1070, at t = 1, 2, and 3, respectively.

D. A Numerical Example of Discounted Debt

In the premium debt case, bondholders invest the premium in installment debt and draw down the install- ment debt balance over time to zero at maturity such that the income per period is maintained. In the case of discounted debt, simply reinvesting the call proceeds in a bond renders the periodic income cash flows larger and the balloon cash flow smaller than they would be without the call. To maintain parity, bondholders must also reinvest the periodic income that is in excess of the original periodic income. Then, at maturity, the accu- mulated amount is withdrawn and added to the bond principal so that the total equals the original bond's balloon cash flow.

To demonstrate that the call price specified in Equa- tion (9b) also provides identical reinvested after-tax cash flows when interest rates have increased (rather than decreased), consider the same parameter values used in the premium debt scenario above, except that the market rate has increased to r = 12%. In this sec- ond case the market value of the bond is $951.96 and the call price is $964.18. Exhibit 2 shows that if the

bond is called, the bondholder reinvests the net amount received, $964.18, in a par value bond that will pay after-tax income of $80.99 each period, which exceeds the $70 per period income if the bond were not called. By reinvesting and accumulating each period's excess income of $10.99, the total accumulation plus par bond principal at maturity equals the balloon payment amount if the bond were not called. So, in total, the bondholder will receive identical after-tax cash flows of $70, $70, $1070, at t = 1, 2, and 3, respectively.

VI. Implementing the Indexed Call Provision

The call price can be specified as a function of either the spot rate or an average yield, over some time peri- od, on government securities of comparable maturity.3 If the government rate on comparable maturity debt is used and expressed as rf, then the bond's yield to ma- turity, r, can be expressed as

r = r, + rp, (12)

where rp

is a fixed risk premium; or, alternatively, r can be expressed as

3Indexes are currently used to set the interest rates on variable rate bonds. For example, General Motors Acceptance Corporation issued $250 million of variable rate notes and set the interest rate at 13.45% for the first year and at 107.2% of the arithmetic average of two specified weekly average yields to maturity of U.S. Treasury securities. These weekly average yields to maturity of U.S. Treasury securities are taken from Statistical Release H. 15, currently published weekly by the Feder- al Reserve Board. These yields are based on yield curves of the most actively traded marketable U.S. Treasury securities. These yield curves are constructed each day, and yield values are then read from the curve at fixed maturities (currently, maturities reported are 1, 2, 3, 4, 5, 7, 10, 20, and 30 years). Using this yield curve, a yield can be estimated for any maturity, even if no outstanding marketable Treasury issue current- ly has that specified remaining maturity.

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62 FINANCIAL MANAGEMENT/AUTUMN 1987

r = (1 + p)rf, (13)

where p is a proportional risk factor. The value of r, or p is specified at the time of the bond's issuance. The bond's surrogate market value at any time, then, is given by Bj in Equation (10), with r determined by a function such as Equation (12) or Equation (13), and the call price for premium and discount debt given, respectively, by Equations (9a) and (9b).

The indexed call provision proposed here is neutral to bondholders and valuable to corporations assuming that the parameter values used to set the call price apply to the marginal investor. Thus, bondholders whose tax rates are equal to those used in calculating Equations (9a) and (9b) will be indifferent to the in- dexed call provision since they receive identical after- tax cash flows regardless of whether or not the bond is called. Of course, determining precisely the correct marginal tax rate is a difficult task. As a practical matter, however, determining the elusive marginal tax rates that will render the call option exactly costless to the corporation is probably not worth the effort, even if it were possible. Whatever tax rates are used in Equa- tions (9a) and (9b) to specify the call price, market participants will produce an equilibrium value that pro- vides the corporation with a fair value for the bond at the time of its issuance. Over a number of issues, the tax rates that render the indexed call provision costless to the corporation can be determined from market equi- librium prices.

Another consideration in attempting to operational- ize the indexed call provision is the question of how transaction costs will affect the bond's market value. For investors to be neutral to the indexed call provi- sion, it may be necessary to increase the call prices specified by Equations (9a) and (9b) by a fixed amount, e.g., $25, to cover the investors' commission cost of reinvesting the proceeds from the call. Again, it is probably necessary to determine the equilibrium amount empirically.

VII. Discussion A. Advantages of the Indexed Call Provision

The example of refunding discounted debt demon- strates a way in which the indexed call provision can be advantageous relative to the fixed-price call provision. Under certain circumstances it is either necessary or desirable for a firm to refund discounted debt. Exam- ples include those where it is necessary to remove one or more of a bond's binding covenants due to a merger

or other policy decision. Examples of possible desir- able situations include those where the firm can avoid the tax liability on the discount [9].

With a fixed-price call provision, paradoxically, an increase in interest rates can impose a significant cost on the firm. If it becomes necessary or desirable for the firm to call the debt when it is selling for a discount, the firm must pay what can amount to a substantial premium above the bond's market value to exercise its (fixed-call price) call option. While the firm can make open-market transactions before exercising its fixed- price call option to minimize the total premium paid, the total cost of repurchasing a fixed-price call provi- sion bond will be higher than the total cost of repur- chasing an indexed call provision bond.

A second advantage of the indexed over the fixed- price call provision involves the cost to the corporation of including the call provision. A fixed-price call pro- vision is paid for with higher coupon payments each period until either the bonds mature or they are called, thereby insuring at least some cost to the firm. In contrast, the indexed call provision is paid for with transaction costs at the time the bonds are called. Thus, the corporation pays for the indexed call provision only if it exercises the option.

A third advantage over the fixed-price call provision is that the indexed call provision eliminates the need for a "no call period." Therefore, the indexed call provision provides additional financial flexibility.

Investors may also view the indexed call provision favorably. A fixed-price call provision forces bond- holders to sell the upper tail of their return distribution that would be realized from a decline in interest rates. Or, viewed alternatively, the fixed-price call provision restricts the bondholder from using the bond to invest in the upper tail of that return distribution. The indexed call provision allows investors to invest in all of the return distribution.4

B. Market Movement Yield changes for a bond can result from either

market-wide interest rate changes or changes in the risk of the individual bond. In an efficient market with no taxes, if the firm holds a fixed-price call option it can benefit from an ex post decrease in market interest rates, whereas the firm cannot benefit from a drop in

4This does not imply that other methods of investing in the upper tail of this return distribution do not currently exist. However, it seems likely that the transaction costs associated with recreating the whole distribu- tion are larger with currently available alternatives since current alterna- tives require investment in multiple securities.

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EMERY, HOFFMEISTER, AND SPAHR/INDEXING A BOND'S CALL PRICE 63

market interest rates when it holds an indexed-price call option. However, at the time of issue the fixed- price call provision is costly to the firm but the indexed call provision is costless. Unless management has spe- cial knowledge of future interest rate movements, the purchase of a fairly priced option is a zero net present value decision. Therefore, whether or not the firm purchases the fixed-price call option will have no im- pact on the firm's value, except for market imperfec- tions such as agency costs and tax asymmetries.

C. Agency Cost Considerations Yield changes for a particular bond that result from

informational asymmetries and firm-specific decisions are the basis for the agency costs outlined by Barnea, Haugen, and Senbet [1]. They show that these agency costs can be eliminated by the proper use of either debt maturity structure or a fixed-price call provision. An indexed call provision can also be used to eliminate these agency costs, but a market value call provision cannot. To see this point, consider the following.

Suppose the resolution of information asymmetries and/or firm-specific decisions have reduced the inter- est rate on a bond and, therefore, increased the value of the bond. If the bond contains a market value call provision the firm cannot benefit from the increase in the value of the bonds (excluding consideration of tax asymmetries or other market imperfections) since the call price equals the bond's market value, whatever that market value is. In contrast, with an indexed call provision, a surrogate market value specifies the call price. The surrogate market value is based on the risk of the bond at the time of issue and changes in it result only from changes in market interest rates. So, if the risk of the individual bond decreases with a commen- surate increase in market value, calling becomes worthwhile because the actual market value will ex- ceed the surrogate market value. Therefore, the in- dexed call provision can be used like a fixed-price call provision to eliminate the agency costs of debt [1].

D. Tax Considerations We do not address the question of optimality with

respect to tax asymmetries here. However, tax benefits accrue to the firm at the time of calling with both the fixed and indexed call provisions [4, 7]. Further, al- though the question remains controversial [3, 4, 5, 7, 11, 15] and the tax reform act of 1986 materially af- fects the answer, the indexed call provision does pro- vide a proper benchmark against which to measure any call provision because the indexed call provision is

costless. Any provision that is said to be superior to the indexed call provision must be shown to be more valu- able to the firm than it is costly to the investor.

VIII. Summary This paper proposes the indexed call provision as an

alternative to the usual fixed-price call provision for use with corporate debt. We have shown that such an option can be constructed to be neutral to the bond- holders and therefore costless to the corporation, ex- cept for transaction costs. Such an indexed call provi- sion bond will have a required rate equal to that of a noncallable bond, which is, of course, less than the required rate on a bond that contains the usual fixed price call provision. Because of differing investor tax rates and transaction costs, the exact parameter values that render the option neutral to the bondholders must be determined empirically. In spite of its being costless to the corporation, the indexed call provision provides all of the benefits that have been attributed to the fixed- price call provision: Financial flexibility, lower trans- action and agency costs, and the elimination of hold- outs. In addition, the indexed call provision (i) reduces the corporation's cost for calling discounted debt, (ii) is costly to the corporation only if the option is exer- cised, and (iii) eliminates the need for a "no call peri- od," thereby providing the corporation with increased financial flexibility.

References 1. A. Barnea, R. Haugen, and L. Senbet, "A Rationale for

Debt Maturity Structure and Call Provisions in the Agency Theoretic Framework," Journal of Finance (December 1980), pp. 1223-1234.

2. Z. Bodie and R. A. Taggart, Jr., "Future Investment Op- portunities and the Value of the Call Provision on a Bond," Journal of Finance (September 1978), pp. 1187-1200.

3. W. Boyce and A. Kalotay, "Tax Differentials and Callable Bonds," Journal of Finance (September 1979), pp. 825- 838.

4. I. Brick and B. Wallingford, "The Relative Tax Benefits of Alternative Call Features in Corporate Debt," Journal of Financial and Quantitative Analysis (March 1985), pp. 95-105.

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JOURNAL OF BUSINESS FINANCE & ACCOUNTING Summer 1987 Editor: Richard Briston Vol. 14 No. 2

Contents Day of the Week Effects on Stock Returns: International Evidence by L. CONDOYANNI, J. O'HANLON AND C.W.R. WARD

Sources of Feedback in a CPA Firm by AHMED BELKAOUI AND RONALD D. PICUR Portfolio Selection Based Upon P/E Ratios: Diversification, Risk Decomposition and Implications by ARTHUR J. KEOWN, JOHN M. PINKERTON AND SON NAN CHEN The Age, Regional, and Industrial Structure of Company Liquidations by JOHN HUDSON

Uncertainty, Capital Immobility and Capital Rationing in the Investment Decision by GEORGE W. TRIVOLI AND WILLIAM R. MCDANIEL Dispersion of Expectations and Trading Volume by EUGENE E. COMISKEY, RALPH A. WALKLING AND MICHAEL A. WEEKS

Assessing Risk and Return of Pension Funds' Portfolios by the Telser Safety-First Approach by MOSHE HAGIGI AND BRIAN KLUGER To Be or Not to Be - Reaction of Stock Returns to Sudden Deaths of Corporate Chief Executive Officers by AHMAD ETEBARI, JAMES O. HORRIGAN AND JAN L. LANDWEHR Is There a Neglected Firm Effect? by STEVEN A. CARVELL AND PAUL J. STREBEL The Forecast Performance of Treasury Bond Futures Contracts by SHANTARAM P. HEGDE

Subscriptions 1987 volume

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Order from Journals Dept., Basil Blackwell Ltd., 108 Cowley Road, Oxford, OX4 1JF, UK. Editorial communications to JBFA/IMRAD, University of Warwick, Coventry CV4 7AL, UK.

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