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Interest Rates & Bonds. Prepared by Keldon Bauer FIL 240. Bond Terminology. Corporate bond: A long-term debt instrument legally obligating the corporation to repay principal and interest according to a prearranged schedule. Indenture:
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Interest Rates & Bonds Prepared by Keldon Bauer FIL 240
Bond Terminology • Corporate bond: • A long-term debt instrument legally obligating the corporation to repay principal and interest according to a prearranged schedule. • Indenture: • A legal contract specifying the rights and restrictions of the borrower and lender. • Trustee is a third party overseeing the indenture.
Bond Security • Secured bond: • Mortgage bond. • Insured. • Unsecured (debenture). • Priority of payment. • Convertible Bonds. • Variable-Rate Bonds. • Putable Bonds
Plans for Paying Off • Staggered Maturities: • Serial payments • Sinking-fund requirement: • A covenant in an indenture for the systematic retirement of bonds prior to maturity. • Call Provision.
Restrictive Covenants • Limitations on Future Borrowings • Restrictions on Dividends • Restrictive Ratios: • Minimum levels of working capital. • Acceptable liquidity and efficiency ratios.
Bond Ratings Junk Bonds
Bond Basics • International bonds • Foreign bond • Eurobonds • Yankee bond
Preferred Stock • Preferred Stock Dividend: • Cumulative on noncumulative. • Preferred Stock Investors: • Generally other corporations since there is a 70% tax exclusion. • Convertible Preferred Stock.
Leasing • Genuine Leases versus Fake Leases • Lease is renting not a purchase. • Definition of Lease: • Remaining life > 20% after lease. • Term of lease ≤ 30 years. • Lessor must earn reasonable return. • Renewal terms must be consistent with value. • Purchase option must be for fair market value. • Leased property cannot be limited-use.
How are leases treated for tax purposes? • Leases are classified by the IRS as either guideline or nonguideline. • For a guideline lease, the entire lease payment is deductible to the lessee. • For a nonguideline lease, only the imputed interest payment is deductible. • Why should the IRS be concerned about lease provisions?
How does leasing affect afirm’s balance sheet? • For accounting purposes, leases are classified as either capital or operating. • Capital leases must be shown directly on the lessee’s balance sheet. • Operating leases, sometimes referred to as off-balance sheet financing, must be disclosed in the footnotes. • Why are these rules in place?
Operating vs. Capital Leases • The lease is a capital lease if at least one of these occurs: • Ownership transfer from lessor to lessee. • Lessee can purchase the property at less than fair market value at end of lease. • The lease runs for a period ≥ 75 percent of asset life. • The PV of the lease payments is ≥ 90% of initial value.
What impact does leasing have on a firm’s capital structure? • Leasing is a substitute for debt. • As such, leasing uses up a firm’s debt capacity.
Assume that Lewis Securities plansto acquire some new equipment having a 6-year useful life. • If the equipment is leased: • Firm could obtain a 4-year lease which includes maintenance. • Lease meets IRS guidelines to expense lease payments. • Rental payment would be $260,000 at the beginning of each year.
Other Information for Lease • Equipment cost: $1,000,000. • Loan rate on equipment = 10%. • Marginal tax rate = 40%. • 3-year MACRS life. • If company borrows and buys, 4 year maintenance contract costs $20,000 at beginning of each year. • Residual value at t = 4: $200,000.
Excel file used in class. • Click here.
