Market Valuation of Interest-Cost Savings from Debt Refinancing

A significant volume of long-term debt was refinanced by corporate America in the early 1990s. We argue that a majority of the refinancing was undertaken to improve the firm's cash flow performance. Firms replacing high-coupon long-term debt with low-coupon debt were able to increase their present and future cash flows because of the low interest rate environment. Since interest-cost savings are certain till the maturity of the debt, the market will capitalize these savings at a higher rate than earnings from other operations. Our cross sectional regression analysis shows that the earnings response coefficient on interest-cost savings is significantly higher than the coefficient on residual earnings from other operations. Overall results suggest that the market was able to unscramble the cash flow implications of debt refinancing and capitalize interest-cost savings in firms' stock prices