FINANCINGFINANCING

Part 2: DebtPart 2: Debt

CHAPTERSCHAPTERS

13-1613-16

LONG-TERM LIABILITIESLONG-TERM LIABILITIESFrom Grade 11From Grade 11

• Long-term liabilities are obligations that are expected to be paid after one year.

• Long-term liabilities include bonds, long-term notes, and lease obligations.

• Advantages of Bonds

1. Shareholder control is not affected.

2. Income tax savings result.

3. Earnings per share may be higher.

EFFECTS OF FINANCING DECISIONSEFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. EquityThe Cost of Financing - Debt vs. Equity

• Disadvantages of Bonds

4. Places cash constraints on the business in the form of:

• regular interest payments• repayment of the Face Value at maturity

Since being solvent is crucial, these MANDATORY payments can put a business in a tight pickle.

5. Reported Net Income is lower.

observe….

EFFECTS OF FINANCING DECISIONSEFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. EquityThe Cost of Financing - Debt vs. Equity

Financing Effects on Accounting Net Income

Operating Income (Income before interest, taxes, and extraordinary items)

Interest Expense (7% of 5,000,000)

Income before Income TaxIncome Tax Expense (40% of Profit)

Net Income

Shares Outstanding

Earnings per share

BONDS SHARES

$1,500,000 $1,500,000(350,000)4

1,150,000(460,000)2

$690,0005

100,0001

$6.903

0

1,500,000(600,000)$900,000

300,000$3.00

PROS: (1) Shareholder control not affected, (2) Income tax is less (3) Earnings per share looks better

CONS: (4) Cash constraint in the form of interest payments (5) Lower reported Net Income

EFFECTS OF FINANCING DECISIONSEFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. EquityThe Cost of Financing - Debt vs. Equity

(200,000 shares @ $25)

EFFECTS OF FINANCING DECISIONSEFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. EquityThe Cost of Financing - Debt vs. Equity

BONDS SHARES

Funds to be raised 5,000,000 5,000,000How’s it done?

1. Issue 50 $100,000 7% Bonds, or2. Issue 200,000 shares at $25 each

5,000,0005,000,000

Annual Cash Payment Bonds (7% of 5,000,000) MANDATORY 350,000

350,000

Annual after-tax cost of Financing 210,000 350,000

Shares (7% dividend) OPTIONALTax savings on interest (40% of $350,000)

Tax savings on dividends(140,000)

0

Financing Effects on Cash Flow – NOT Profit

After-tax cost 4.2% 7%

Note how a 7% before-tax interest CASH cost, turns into a 4.2% after-tax CASH cost. This is because interest expenses are tax

deductible, and the lower tax payment means less cash paid out.

This means that Financing with debt will produce less accounting PROFIT, but will be cheaper in terms of real CASH.

However, debt isn’t always better in terms of less cash paid out. Remember that dividends are OPTIONAL, so there may in fact be NO cash payment with a share issue (though issuing shares raises

other concerns).

TYPES OF BONDSTYPES OF BONDS

• Secured bonds have collateral pledged for the bonds in case of default.

• Unsecured bonds are issuedbased on the credit rating of the borrower. (Generally require a higher interest rate).

TYPES OF BONDSTYPES OF BONDS

• Registered bonds are issued in thename of the owner (interest payments are made

by cheque to bondholders on record). • Bearer (or coupon) bonds are not

registered; bondholders must send in coupons to receive interest payments. (Rare because vulnerable to theft)

TYPES OF BONDSTYPES OF BONDS

• Convertible bonds permit bondholders to convert the bonds into common shares at their option.

• Redeemable, retractable or callable

bonds can be retired early (before maturity) at a stated amount at the option of the issuer or holder.

BOND TERMINOLOGYBOND TERMINOLOGY

• The face value is the amount of principal due at the maturity date.

• The contractual interest rate or coupon rate, or stated rate, is the rate used to determine interest.

• Interest paid is the FACE VALUE x Interest paid is the FACE VALUE x STATED RATE, regardless of the price STATED RATE, regardless of the price paid for the bond or prevailing interest paid for the bond or prevailing interest rates!!!rates!!!

THE MARKET VALUE OF BONDSTHE MARKET VALUE OF BONDSThe market value (or Net Present Value - NPV) of any

investment is equal to the present value of all the future cash payments it promises.

Ask yourself, will your $100,000 buy as

much now…

…as it will 5 years from now?

So does that mean that the NPV is just a matter of adding up the cash payments

over the years?

0 1 2 3 4 5

$100,000 $100,000They look the same.

But are they?

YearsYears

• This is because of the time value of money• Inflation (rising prices) changes the value of

money (i.e. it changes apples into oranges). • It does this by eroding money’s purchasing

power.• Since you can’t add apples and oranges, you can’t

add cash flows together over the years either. You must find NPV another way.

THE MARKET VALUE OF BONDSTHE MARKET VALUE OF BONDS

$100,000 $100,000

THE MARKET VALUE OF BONDSTHE MARKET VALUE OF BONDS

• The market value (NPV or Net Present Value) is a function of three factors: – the cash flows to be received,– the length of time (n) until the amounts are

received, and – the market rate of interest (i) which is the rate

investors demand for loaning funds to the corporation.

• Finding the NPV is referred to as discounting.

THE MARKET VALUE OF BONDSTHE MARKET VALUE OF BONDSEffect Of Interest Rates On Bond PricesEffect Of Interest Rates On Bond Prices

Bond Contractual

Interest Rate of 5%

Bond Contractual

Interest Rate of 5%

4%4%

5%5%

6%6%

PremiumPremium

Face ValueFace Value

DiscountDiscount

If issued when

Market Interest Bonds SellRates at

0 1 2 3 4 5

YEAR

MARKET VALUE OF A BONDMARKET VALUE OF A BONDPresent Value Calculations (i.e. Present Value Calculations (i.e. Discounting))

$100,000Principle:

Interest: $10,000 $10,000 $10,000 $10,000 $10,000

$100,000

Assume we purchase from the Bond market a $100,000, 10%, 5-year bond. At time of purchase, market interest rates are also 10%.

Present Value to Us:Present Value to Us:

$9,091$8,264$7,513

$68,302$6,830

Can you guess what the total is?$100,000

Now you must DISCOUNT the future cash flows that will stream from this Bond to find out what they are currently

worth.

To do this you must do the following for EVERY stream of Cash in EVERY period:

Cash Stream .

(1 + Market Interest Rate) Number of years away

$10,000

(1.10)1$10,000

(1.10)2

$10,000

(1.10)3

$10,000

(1.10)4$110,000

(1.10)5

0 1 2 3 4 5YEAR

MARKET VALUE OF A BONDMARKET VALUE OF A BONDWhen Market Interest Rate DiffersWhen Market Interest Rate Differs

$100,000Principle:

Interest: $10,000 $10,000 $10,000 $10,000 $10,000

$100,000

Now assume the same bond ($100,000, 10%, 5-year), is bought when the market rate of interest is 12%.

Present Value to Us:Present Value to Us:

$8,929$7,972$7,118

$62,417$6,355

Can you guess what the total is now?$92,790

Nothing has changed, the discounting formula is the same:

Cash Stream .

(1 + Market Interest Rate) Number of years away

$10,000

(1.12)1$10,000

(1.12)2

CALCULATING THE PRESENT CALCULATING THE PRESENT VALUE OF BONDSVALUE OF BONDS

• The easiest way to value a bond is using annuity and present value tables (they appear in the back of your text).

Present value of $100,000 received in 5 periods$100,000 x 0.56743 (Table B-1: n=5, i=12%) $ 56,743

Present value of $10,000 received annually for 5 periods$10,000 x 3.60478 (Table B-2: n=5, i=12%)

36,047

Present (market) value of bonds $92,790Click for Excel File

Do Handouts:

ACCOUNTING FOR BOND ISSUESACCOUNTING FOR BOND ISSUES

Bonds may be issued at:

1. Face value

2. Discount (below face value), or

3. Premium (above face value).

NOTE:

Once again, I recommend you start a fresh page and make a chart in your notes like this one (leave enough space for

a journal entry in each section):

1. Face Value 2. Discount 3. Premium

Bond Issue

Interest Payment

Recall

1.1. FACE VALUEFACE VALUEBond IssueBond Issue

• On January 1st of this year, we issued a $100,000 12% 5-year note.

• Market interest rates were 12%

Date Particulars Debit CreditJan 1 Cash 100,000

Bonds Payable 100,000

To record issue of Bonds at face value.

1.1. FACE VALUEFACE VALUEInterest PaymentInterest Payment

On December 31st, the following journal entry would be made:

Date Particulars Debit CreditDec 31 Bond Interest Expense 12,000

Cash 12,000

To record payment of bond interest.

1.1. FACE VALUEFACE VALUERecallRecall

On February 1st of the SECOND YEAR, we recall the bond for $100,000.

Date Particulars Debit CreditFeb 1 Bonds Payable 100,000

Cash 101,000

To recall the bond.

Interest Expense 1,000

2. DISCOUNT2. DISCOUNTBond IssueBond Issue

• On January 1, we sell $100,000, 12%, 5-year, bonds at 93.134 (93.134 percent of face value).

• The market interest rate was 14% at the time.

Date Particulars Debit CreditJan 1 Cash 93,134

Bonds Payable 100,000

To record issue of Bonds payable at a discount.

Discount on Bonds Payable 6,866

BEFORE WE MOVE ONBEFORE WE MOVE ON::Amortizing Bond Discounts and PremiumsAmortizing Bond Discounts and Premiums

• Due to the matching principle, a bond discount/premium should be amortized over the life of the bond (just as interest is).

• The method used is straight-line.

• The text discusses another method; IGNORE IT.

STRAIGHT-LINE METHOD OF BOND STRAIGHT-LINE METHOD OF BOND DISCOUNT AMORTIZATIONDISCOUNT AMORTIZATION

=Bond

DiscountNumber of

Interest PeriodsBond Discount Amortization

NOTE:Over the term of a bond, the balance in a Discount OR Premium

will decrease annually by the same amount until it reaches zero at the maturity date of the bonds.

Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds.

2. DISCOUNT2. DISCOUNTInterest PaymentInterest Payment

The entry to record interest on December 31st is:

Date Particulars Debit CreditDec 31 Interest Expense 13,373

Cash 12,000

To record interest payment for first year’s interest.

Discount 1,373

• The $94,507 represents the carrying (or book) value of the bonds.

• On the date of issue, this amount equals the market price of the bonds $93,134.

• On the date of maturity carrying value equals face value ($100,000).

2. DISCOUNT2. DISCOUNTStatement PresentationStatement Presentation

Long-term liabilitiesBonds payableLess: Discount on bonds payable

$ 100,000 (5,493) $94,507

EARLY BOND RETIREMENTSEARLY BOND RETIREMENTS

• Bonds may be redeemed before maturity because a company may decide to reduce interest cost and remove debt from its balance sheet.

• Similar to disposing of an asset, when bonds are retired before maturity you must:

1. Update interest to date of disposal,2. Eliminate all accounts associated with the Bond

(including discounts and premiums)3. Record the cash paid, and 4. Recognize a gain or loss on redemption and report as

extraordinary in the income statement.

2. (Back to it) DISCOUNT2. (Back to it) DISCOUNTRecallRecall

The entry to recall the Bond for $100,000 on Feb 1st of YEAR TWO is:

Date Particulars Debit Credit

Feb 1 Interest Expense 1,114

Cash 1,000Bond Discount 114

Date Particulars Debit Credit

Feb 1 Bonds Payable 100,000

Cash 100,000Bond Discount 5,379

Loss on Recall of Bonds 5,379

To record interest up to date for disposal.

To dispose of the bond.

3. PREMIUM3. PREMIUMBond IssueBond Issue

We issued a $100,000, 12%, 5-year Bond on January 1st. Market interest rates are 10%.

Date Particulars Debit Credit

Jan 1 Cash 107,582

Bonds Payable 100,000

To record issue of bonds with a premium.

Premium on Bonds 7,582

3. PREMIUM3. PREMIUMInterest PaymentInterest Payment

Date Particulars Debit Credit

Dec 31 Interest Expense 10,484

Cash 12,000

To record issue of bonds with a premium.

Bond Premium 1,516

To record the interest at the end of the FIRST YEAR, we make the following entry:

The $106,066 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds. At maturity it will equal the face value ($100,000).

STATEMENT PRESENTATION OF STATEMENT PRESENTATION OF BONDS PREMIUMBONDS PREMIUM

Long-term liabilitiesBonds payableAdd: Premium on bonds payable

$100,000 6,066 $106,066

3. (Back to it) PREMIUM3. (Back to it) PREMIUMRecallRecall

The entry to recall the Bond for $100,000 on Feb 1st of YEAR TWO is:

Date Particulars Debit Credit

Feb 1 Interest Expense 876

Cash 1,000Bond Premium 126

Date Particulars Debit Credit

Feb 1 Bonds Payable 100,000

Cash 100,000Gain on Recall of Bonds 5,940

Bond Premium 5,940

To record interest up to date for disposal.

To dispose of the bond.

MORTGAGESMORTGAGES

• Mortgage notes payable are widely used in the purchase of homes by individuals and in the acquisition of capital assets by many small and some large companies.

• They differ from bonds in that some of the Principle (face value) is repaid each month with the interest payment.

• Mortgages are like secured bonds in that they have collatoral.

MORTGAGE NOTES PAYABLEMORTGAGE NOTES PAYABLE

• Mortgage notes payable are recorded at face value and entries are required subsequently for each installment.

1. To record interest2. To reduce the principle

• On the balance sheet, the portion of principle for the next 12 months is reported as a current asset (current portion of mortgage payable).

• The rest of the mortgage is classified as a long-term liability.

DEBT TO TOTAL ASSETSDEBT TO TOTAL ASSETS

The debt-to-total-assets ratio indicates the percentage of total assets owed to creditors, providing one measure of leverage. It is calculated by dividing total debt by total assets.

The debt-to-total-assets ratio indicates the percentage of total assets owed to creditors, providing one measure of leverage. It is calculated by dividing total debt by total assets.

Total Debt Total AssetsDebt to

Total Assets

TIMES INTEREST EARNEDTIMES INTEREST EARNED

The times interest earned measures the company’s ability to meet interest payments as they come due. It is calculated by dividing income before interest expense and income tax expense by interest expense.

The times interest earned measures the company’s ability to meet interest payments as they come due. It is calculated by dividing income before interest expense and income tax expense by interest expense.

Net Income + Interest Expense +

Income Tax Expense

Interest Expense

Times Interest Earned