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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

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.

- 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.

- 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:
- Land100,000
- Mortgage Payable 100,000
- At the time of first payment?

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

- 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.

- i% = 6PV = 100 N = 5FV = 100 * 1.3382

PV = 100 FV =

0 5

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.

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

- 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

0 1 2 3

- PVA = 1,000 (3 yrs., 8% factor from the PVA table)
- PVA = 1,000 * (2.5771)
- PVA = $2,577.10

Present

Value

10001000 1000

- 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

- 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.

- 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.

- 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

- 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.

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

- How would the issuance of the bonds at a discount be recorded in the journal?
- DateTransaction DebitCredit

May 1 Cash 864,100

Discount on bond payable135,900

Bonds payable 1,000,000

- 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.

- How would the issuance of the bonds at a premium be recorded in the journal?
- DateTransaction DebitCredit

May 1 Cash 1,067,955

Premium on bond payable 67,955

Bonds payable 1,000,000

- 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

- 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

- How would the first interest payment be recorded in the journal?
- DateTransaction DebitCredit

Interest expense 34,800

Discount on bond payable 4,800

Cash 30,000

- How would the second interest payment be recorded in the journal?
- DateTransaction DebitCredit

Interest expense 34,992

Discount on bond payable 4,992

Cash 30,000

- 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

- 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

- How would the first interest payment be recorded in the journal?
- DateTransaction DebitCredit

Nov 1 Interest expense 42,800

Premium on bond payable 2,200

Cash 45,000

- How would the first interest payment be recorded in the journal?
- DateTransaction DebitCredit

May 1 Interest expense 42,712

Premium on bond payable 2,288

Cash 45,000