analysis of financing liabilities. focus understand the fs effects of issuing a bond at par, at a...
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ANALYSIS OF FINANCING LIABILITIES
FOCUS
• Understand the FS effects of issuing a bond at par, at a discount, or at a premium.
• Calculate the book value of the bond and interest expense at any point of time using the effective interest rate method.
• Calculate the gain or loss from retiring a bond before its maturity date
FINANCING LIABILITIES
• A bond is a contractual promise between a borrower and a lender that obligates the bond issuer to make payments to the bondholder over the term of the bond.
• Two types: periodic interest payments, repayment of principal at maturity.
• The face value: maturity value/ par value: the amount of principal that will be paid to the bondholder at maturity used to calculate the coupon payments.
• The coupon rate: the interest rate stated in the bond used to calculate the coupon payments.
• The coupon payments: the periodic interest payments to the bondholders.
• The effective rate of interest: interest rate that equates the present value of the future CF of the bond and the issue price.
• The balance sheet liability: equal to the present value of its remaining CF, discounted at the market rate of interest at issuance.
• The interest expense: is calculated by multiplying the book value of the bond liability at the beginning of the period by the market rate of interest of the bond when it was issued.
• The market rate = coupon rate par bond (priced at face value)
• Market rate > coupon rate discount bond (priced below par)
• Market rate < coupon rate premium bond (priced above par)
EXAMPLE: BOOK VALUES AND CF
• On Dec 31, 20X2, a company issued a 3 year, 10% annual coupon bond with a face value of $100,000. Calculate the book value of the bond at year – end 20X2, 20X3, 20X4 and the interest expense for 20X3, 20X4 and 20X5, assuming the bond was issue at a market rate of interest of 10%, 9% and 11%
FS EFFECTS OF ISSUING A BOND• Cash flow impact of issuing a bond
Cash flow from financing
Cash flow from operations
Issuance of debt Increased by cash received
No effect
Periodic interest payments
No effect Decreased by interest paid
Payment at maturity
Decreased by face value
No effect
• Income statement impact of issuing a bondInterest expense = market rate at issue x balance sheet value of liability
at beginning of periodIssued at par Issued at premium Issued at a discount
Market rate = coupon rate
Market rate < coupon rate
Market rate > coupon rate
Interest expense = coupon rate x face value = cash paid
Interest expense = cash paid – amortization of premium
Interest expense = cash paid + amortization of discount
Interest expense is constant
Interest expense decreases over time
Interest expense increases over time
• Balance sheet impact of issuing a bond
Issued at par Issued at a premium Issued at a discount
Carried at face value
Carried at face value plus premium
Carried at face value less discount
The liability decreases as the premium is amortized to interest expense
The liability increases as the discount is amortized to interest expense
THE ROLE OF DEBT COVENANTS IN PROTECTING CREDITORS
• Debt covenant: restrictions imposed by the lender on the borrower to protect the lender’s position.
• Can reduce default risk and reduce borrowing costs.
• The restrictions can be in the form of affirmative covenants or negative covenants.
AFFIRMATIVE COVENANTS
• Make timely payments of principal and interest
• Maintain certain ratios in accordance with specified levels.
• Maintain collateral
NEGATIVE COVENANTS
• Increasing dividends or repurchasing shares.• Issuing more debt.• Engaging in mergers and acquisitions.
DISCLOSURES RELATING TO DEBT• Balance sheet• Footnote disclosure
The nature of the liabilitiesMaturity datesStated and effective interest ratesCall provisions and conversion privilegesRestrictions imposed by creditorsAssets pledged as securityThe amount of debt maturing in each of the next five
years
MOTIVATIONS FOR LEASING INSTEAD OF PURCHASING THEM
• Finance lease:
a purchase of an asset that is financed with debt.
The lease will add equal amounts to both assets
and liabilities on the balance sheet,.
the lease will recognize depreciation expense on
the asset and interest expense on the liability.
• Operating lease:
Is essentially a rental arrangement
Not asset or liability is reported by the lessee
The periodic lease payments are simply recognized
as rental expense in the income statement.
CERTAIN BENEFIT FROM LEASING
• Less costly financing• Reduced risk of obsolescence• Less restrictive provisions• Off balance sheet financing• Tax reporting advantages
DISTINGUISH FINANCE LEASE AND OPERATING LEASE
• LESSEE’S PERSPECTIVE: require a lease to be treated as a finance lease, include:
- Title to the leased asset is transferred to the lessee at the end of the lease.
- The lease term covers a major portion of the asset’s economic life (75% or more)
- The present value of the lease payment is 90% or more of the fair value of the leased asset
• LESSOR’S PERSPECTIVE:- Finance lease: all rights and risks of ownership
are transferred to the lease- Operating lease: the lessor recognizes rental
income and continues to report and depreciate the leased asset on its balance sheet.
DETERMINE THE INITIAL RECOGINITION AND MEASURMENT • REPORTING BY THE LEASE:- Operating lease:
the balance sheet is unaffected. No asset or liability is reported by the lessee. During the term of the lease, rent expense equal
to the lease payment is recognized in the lessee’s income statement.
In the CFS, the lease payment is reported as an outflow from operating activities
• Finance lease:
The lower of the present value of future minimum lease
payments or the fair value of the leased asset is recognized
as both an asset and liability on the lessee’s balance sheet.
The asset is depreciated in the income statement and
interest expense is recognized.
Interest expense is equal to the lease liability at the
beginning of the period multiplied by the lease interest
rate
FS AND RATIO EFFECTS OF OPERATING AND FINANCE LEASES
• Balance sheet:- A finance lease results in a reported asset and a liability.- Turnover ratios that use total or fixed assets in their
denominators will be lower when a lease is treated as a finance lease.
- ROA will also be lower for finance leases.- Leverages ratio, debt to assets ratio, debt to equity will
be higher with finance leases then operating leases.
• Income statement:
EBIT will be higher for companies that use finance
leases relative to companies that use operating
leases.
Operating lease: entire lease payment is an
operating expense
Finance lease: only depreciation of the leased asset
is treated as an operating expense.
• Cash flow statement:- Total cash flow is unaffected by the
accounting treatment of a lease.- If the lease is treated as an operating lease
the total cash payment reduces cash flow from operations.
- If the lease is treated as a finance lease the portion of the lease payment that is considered interest expense reduces CF from operations.
FINANCE LEASE OPERATING LEASE
Assets Higher Lower
Liabilities (current and long term)
Higher Lower
Net income (in the early years)
Lower Higher
Net income (later years)
Higher Lower
Total net income Same Same
EBIT (operating income)
Higher Lower
CF from operations Higher Lower
CF from financing Lower Higher
Total cash flow Same Same
FINANCE LEASE OPERATING LEASE
Current ratio Lower Higher
Working capital Lower Higher
Asset turnover Lower Higher
Return on assets Lower Higher
Return on equity Lower Higher
Debt/ Assets Higher Lower
Debt/ Equity Higher Lower