A:

When a company refinances its debt, it can take one or both of the following actions:

  • Restructuring or replacing the debt, generally with a longer time to maturity and/or lower interest rate, or
  • Issuing new equity to pay down the debt load. This option is generally exercised when the company can't access traditional credit markets and is forced to turn to equity financing

Most times, companies refinance or restructure their debt when they are in financial difficulty and unable to meet their obligations, generally prior to filing for Chapter 11 bankruptcy protection. However, favorable market conditions or the strengthening of a company's credit rating may lead to the refinancing of corporate debt. The two primary factors for influencing a company not in financial distress to refinance are decreases in the interest rate or improvements in the company's credit quality.

When a company issues debt, usually in the form of long-term bonds, it is agreeing to pay a periodic interest charge, known as a coupon, to the bondholders. The coupon rate reflects the current market interest rates and the company's credit rating.

The Role of Interest Rates

When interest rates drop, the company will want to refinance its debt at the new rate. Because the debt was issued during a time of higher interest rates, the company is paying more in interest than what current market conditions would specify. In this case, the company may refinance by issuing new bonds at the lower coupon rate and use the proceeds to buy back the older bonds. This allows the company to capitalize on the lower interest rate, which allows it to pay a smaller interest charge.

A company's credit rating is reflected in the coupon rate on newly issued debt. A less-financially secure company will need to offer lenders more of an incentive -- in the form of a higher interest rate -- to compensate them for the additional risk of extending credit in that company. When a company's credit quality improves, investors won't require such a high interest rate because that company's bonds will be a safer investment. If lenders are requiring a lower return than before, a company will probably want to refinance its older debt at the new rate.

After the company refinances its debt, it generally reaps several benefits, including improved operational flexibility, more time to execute a specific business strategy and, in most cases, a more attractive bottom line due to decreased interest expense. (See also: When Companies Borrow Money.)

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