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Chapter 8 Special Acquisitions: Financing a Business with Debt

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Chapter 8 Special Acquisitions: Financing a Business with Debt Business Background Capital structure is the mix of debt and equity used to finance a company. DEBT: Loans from banks and insurance companies are often used when borrowing small amounts of capital.

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Chapter 8
  • Special Acquisitions: Financing a Business with Debt
business background
Business Background

Capital structure is the mix of debt and equity used to finance a company.

  • DEBT:
  • Loans from banks and insurance companies are often used when borrowing small amounts of capital.
  • Bonds are debt securities issued when borrowing large amounts of money (issued in denominations of $1,000)
    • Can be issued by either corporations or governmental units.
notes payable and mortgages
Notes Payable and Mortgages
  • When a company borrows money from the bank for longer than a year, the obligation is called a long-term note payable.
  • A mortgage is a special kind of “note” payable--one issued for property.
  • These obligations are frequently repaid in equal installments: part of the installment is repayment of principal and part is payment of interest.
example borrowing to buy land by using a mortgage
Example: Borrowing To Buy Land By Using A Mortgage
  • ABC Co. signed a $100,000, 3 yr. mortgage (for a piece of land) which carried an 8% annual interest rate. Payments are to be made annually on December 31 of each year for $38,803.35.
  • How would the mortgage be recorded?
  • What is the amount of the liability (mortgage payable) after the first payment is made?
  • Upon signing the mortgage:
  • Land 100,000
  • Mortgage Payable 100,000
  • At the time of first payment?
amortization schedule
Amortization Schedule

Principal Balance

Reduction in Principal

Payment

Interest

100,000.00

38,803.35 38,803.35 38,803.35

8,000.00

30,803.35

69,196.65

5,535.73*

33,267.62

35,929.03

2,874.32**

35,929.03

time value of money
Time Value of Money
  • The example of the mortgage demonstrates that money has value over time.
  • When you borrow $100,000 and pay it back over three years, you have to pay back MORE than $100,000.
  • Your repayment includes interest--the cost of using someone else’s money.
  • A dollar received today is worth more than a dollar received in the future.
  • The sooner your money can earn interest, the faster the interest can earn interest.
  • Interest is the return you receive for investing your money. You are actually “lending” your money, so you are paid for letting someone else use your money.
  • Compound interest -- is the interest that your investment earns on the interest that your investment previously earned.
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Future value – single sumIf You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years?
  • i% = 6 PV = 100 N = 5 FV = 100 * 1.3382

PV = 100 FV =

0 5

slide8

The Value of a Series of Payments

  • The previous example had a single payment. Sometimes there is a series of payments.
  • Annuity: a sequence of equal cash flows, occurring at the end of each period.
  • When the payments occur at the end of the period, the annuity is also known as an ordinary annuity.
  • When the payments occur at the beginning of the period, the annuity is called an annuity due.
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0 1 2 3

If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years?This is an ordinary annuity – annuity in arrears – deposits at the end of the period

Future Value of an Annuity

1,000

1,000

1,000

FVA = 1,000 * [value from FVA table, 3yrs. 8%]

FVA = 1,000 * 3.2464 = $3,246.40

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Present value – single sum If you will receive $100 one year from now, what is the PV of that $100 if the relevant interest rate is 6%?
  • PV = FV (PV factor i, n )
  • PV = 100 (0.9434 ) (from PV of $1 table)
  • PV = $94.34

PV = 94.34 FV = 100

0 1

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0 1 2 3

Present value of ordinary annuity - What is the PV of $1,000 at the end of each of the next 3 years, if the interest rate is 8%?
  • PVA = 1,000 (3 yrs., 8% factor from the PVA table)
  • PVA = 1,000 * (2.5771)
  • PVA = $2,577.10

Present

Value

1000 1000 1000

characteristics of bonds payable
Characteristics of Bonds Payable
  • Bonds usually involve the borrowing of a large sum of money, called principal.
  • The principal is usually paid back as a lump sum at the end of the bond period.
  • Individual bonds are often denominated with a par value, or face value, of $1,000.
  • Bonds usually carry a stated rate of interest.
  • Interest is normally paid semiannually.
  • Interest is computed as:
  • Interest = Principal × Stated Rate × Time
measuring bonds payable and interest expense
Measuring Bonds Payable and Interest Expense
  • The interest rate used to compute the present value is the market interest rate.
    • Also called yield, effective rate, or true rate.
  • Creditors demand a certain rate of interest to compensate them for the risks related to bonds.
  • The stated rate, or coupon rate, is only used to compute the periodic interest payments.
bond prices
Bond Prices
  • Example 1 - $1,000, 6% stated rate.
  • The market rate of interest is 8%.
  • Who would buy my bond?
  • Nobody---so I’ll have to sell (issue) it at a discount.
  • e.g., bondholders would give me something less for the bond.
  • Example 2 - $1,000, 6% stated rate.
  • The market rate of interest is 4%.
  • Who would buy these bonds?
  • EVERYONE!
  • So the market will bid up the price of the bond; e.g., I’ll get a little premium for it since it has such good cash flows.
  • Bondholders will pay more than the face.
determining the selling price
Determining the Selling Price
  • Bonds sell at:
    • “Par” (100% of face value)
    • less than par (discount)
    • more than par (premium)
  • Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond)
  • Therefore, if
  • market rate = stated rate - Bonds sell at par value
  • market rate > stated rate – Bonds sell at a discount
  • market rate < stated rate – Bonds sell at a premium
proceeds of a bond issue bond selling price
Proceeds Of A Bond Issue – Bond selling price
  • To calculate the issue price of a bond, you must find the present value of the cash flows associated with the bond. Determine N and i.
  • Then, find the present value of the interest payments (Principal * stated rate* time) using the market rate of interest. Do this by finding the PV of an annuity.
  • Then, find the present value of the principal payment at the end of the life of the bonds using the market rate of interest. Do this by finding the PV of a single amount.
  • Example
  • On May 1, 1991, Clock Corp. sells $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years, and interest is paid semiannually. The market rate is 8% annually.
two parts to the calculations
INTEREST PAYMENTS

PV of an ordinary annuity of $30,000 for 20 periods at an interest rate of 4%:

Use a calculator or a PV of an annuity table:

30,000 (PVA,,4%, 20)=

30,000 (13.59033) =

407,710

PRINCIPAL PAYMENT

PV of a single amount of $1 million at the end of 20 periods at an interest rate of 4%:

Use a calculator or a PV of a single amount table:

1,000,000 (PV,,4%, 20)=

1,000,000 (.45639)=

456,390

Selling price = 407,710 + 456,390 = 864,100

Bonds sold at 86.41

Two parts to the calculations
recording bonds sold at a discount
Recording Bonds Sold at a Discount
  • How would the issuance of the bonds at a discount be recorded in the journal?
  • Date Transaction Debit Credit

May 1 Cash 864,100

Discount on bond payable 135,900

Bonds payable 1,000,000

bond selling price example
Bond Selling Price -- Example
  • On May 1, 1991, Magic Inc. sells $1,000,000 in bonds having a stated rate of 9%annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually.
  • Determine bond selling price.
  • N = 20 I = 4%
  • {1,000,000 * 4.5% * 13.59033} + { 1,000,000 * 0.45639}
  • = 611,565 + 456,390 = 1,067,955
  • Bonds issued at a premium.
recording bonds sold at a premium
Recording Bonds Sold at a Premium
  • How would the issuance of the bonds at a premium be recorded in the journal?
  • Date Transaction Debit Credit

May 1 Cash 1,067,955

Premium on bond payable 67,955

Bonds payable 1,000,000

measuring and recording interest on bonds issued at a discount
Measuring and Recording Interest on Bonds Issued at a Discount
  • The discount must be amortized over the outstanding life of the bonds.
  • The discount amortization increases the periodic interest expense for the issuer.
  • Two methods are commonly used:
    • Effective-interest amortization
    • Straight-line amortization
discount amortization
Discount Amortization
  • Clock Corporation sold $1,000,000, 6%, 10 –year bonds on January 1, 2000 at 87(sold at 870,000). The market rate of interest = 8%. The bonds pay interest semiannually.
  • Face value of bonds = $1,000,000
  • Discount on bonds = $130,000
  • Carrying value of bonds at issuance = selling price = $ 870,000
  • The discount will be amortized as interest expense over the life of the bonds
  • Discount bonds
  • Interest expense = Cash paid for interest every period + Amount of discount amortized
  • Interest expense > Cash paid for interest – Why?
  • Carrying value = Face value – Unamortized discount
recording the first interest payment on bonds sold at a discount
Recording the First Interest Payment on Bonds Sold at a Discount
  • How would the first interest payment be recorded in the journal?
  • Date Transaction Debit Credit

Interest expense 34,800

Discount on bond payable 4,800

Cash 30,000

recording the second interest payment on bonds sold at a discount
Recording the Second Interest Payment on Bonds Sold at a Discount
  • How would the second interest payment be recorded in the journal?
  • Date Transaction Debit Credit

Interest expense 34,992

Discount on bond payable 4,992

Cash 30,000

measuring and recording interest on bonds issued at a premium
Measuring and Recording Interest on Bonds Issued at a Premium
  • The premium must be amortized over the term of the bonds.
  • The premium amortization decreases the periodic interest expense for the issuer.
  • Two methods are commonly used:
    • Effective-interest amortization
    • Straight-line amortization
premium amortization
Premium Amortization
  • Magic Inc. sold $1,000,000, 9%, 10-year bonds on January 1, 2000 at 107 (sold at 1,070,000). The market rate of interest is 8%.
  • Face value of bonds = 1,000,000
  • Premium on bonds = 70,000
  • Carrying value of bonds initially = 1,070,000
  • The premium will be amortized over the life of the bonds and it will reduce interest expense
  • Premium bonds
  • Interest expense = Cash paid for interest every period - Amount of premium amortized
  • Interest expense < Cash paid for interest – Why?
  • Carrying value = Face value + Unamortized premium
recording the first interest payment on bonds sold at a premium
Recording the First Interest Payment on Bonds Sold at a Premium
  • How would the first interest payment be recorded in the journal?
  • Date Transaction Debit Credit

Nov 1 Interest expense 42,800

Premium on bond payable 2,200

Cash 45,000

recording the second interest payment on bonds sold at a premium
Recording the Second Interest Payment on Bonds Sold at a Premium
  • How would the first interest payment be recorded in the journal?
  • Date Transaction Debit Credit

May 1 Interest expense 42,712

Premium on bond payable 2,288

Cash 45,000

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