On the Call Provision in Corporate Zero-Coupon Bonds

M. P. Narayanan and Suk-Pil Lim

Journal of Financial and Quantitative Analysis, 1989, vol. 24, issue 1, 91-103

Abstract: A majority of corporate zero-coupon bonds includes a call provision, giving the firm the right to call the bond at par value. In this paper, we investigate whether or not it is optimal for the firm to call such a bond for refunding purposes, taking into consideration the effect of corporate taxes. We find that it is not optimal to refund the bond as long as the corporate tax rate is less than 50 percent. We find that a significantly higher proportion of callable zero-coupon bonds, compared to noncallables, has restrictive financing covenants, suggesting that the call feature is included to provide flexibility at a low cost for future recapitalizations as the firm's investment opportunities change.

Date: 1989
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