Sources of Capital: Debt

1. 8 Sources of Capital:Debt

2. Liability • Definition • Obligation to an outside party. • Arises from a transaction or an event that has already happened. • Estimated warranty is an example of a liability that is not legally enforceable.

3. Legal obligations that are not accounting liabilities • Executory contracts = contracts in which neither party has yet performed. • Sales contract for future delivery of certain goods to the buyer. • Contract to pay a baseball player $1 million per year for five years. • A contract to provide legal services next year.

4. Are these liabilities? • Receive $50,000 retainer for legal services to be performed on an as-needed basis next year. • Purchase contract for future delivery of certain goods from the seller. • Seller of a house receives $10,000 as a non-refundable deposit.

5. Contingency • Uncertainty as to possible gain or loss that will ultimately be resolved by some future event. • Gain contingencies usually not reported (conservatism).

6. Loss Contingency • Potential future payment from existing conditions. • Uncertainty about amount. • Outcome will be resolved by future events.

7. Levels of likelihood/GAAP • Probable • Reasonably estimated/Accrue. • Not reasonably estimated/Disclose • Reasonably possible/Disclose • Remote/No accrual; no disclosure.

8. Contingent liabilities on FS? • Expect to be sued due to damage caused by our product. Outcome unknown. • Pending lawsuit. Probable loss from $100K to $2KK. (Reasonably possible?) • Lawsuit pending. Remote chance of loss. • Sales during year were $1KK. Products warranted for 1 year. Historically, • Warranty costs are 3% of sales. • Bad debts are 2% of sales.

9. Sources of funds • Debt capital. • Company pays for use of capital that others furnish. • Equity capital. • Obtained from shareholders. • Direct contribution (paid-in capital). • Indirect contribution (retained earnings).

10. Debt Capital • Debt instruments. • Term loans. • Repayable according to a specified schedule usually with equal installments of principal and interest. • Bond. • Certificate promising to pay its holder: • Specified sum of money at a stated date and • Interest at a stated rate until maturity. • Price quoted as % of face, e.g., 98 or 102.

11. Bonds • Interest rate usually constant through life, could be variable (variable-rate bonds). • Bond indenture • Contains covenants which are requirements such as maintaining certain minimum financial ratios. • If covenants are not met, then loan is technically in default; creditors can demand immediate payment or changes to be made by management. • Mortgage bond is secured by pledged assets. • Debenture bond is not secured by specific assets.

12. Bond redemption • Payment of principal at maturity of bonds. • Thus, cancellation (under some circumstances earlier than maturity). • Sinking fund bonds. • Require setting aside cash/investments to be used to redeem bonds at maturity or at regular intervals. • Sinking funds are controlled by a trustee (e.g., a bank). • Shown on BS as Investments or other assets.

13. Other bond features • Serial. • Redeemed in installments. Redemption date specified on bond itself. • Convertible. • Bondholder has the right to exchange bond for specified # of shares of stock. • Subordinated. • Claims are inferior to claims of general or secured creditors but take precedence over claims of shareholders. • Zero coupon bonds. No interest is paid. Issued at deep discount. • Callable.

14. Terms • Par value = face value = principal value = maturity value. • Coupon rate = stated interest rate. • Interest payments = face value * stated interest rate. • Issuance costs: investment banking, accounting, legal and printing fees. • Deferred charges amortized over life of bonds using SL method.

15. Accounting for Bonds • Issuance at par - no issuance costs • Cash 100 • Bonds payable 100

16. Issuance at par - with issuance costs Cash 100 Deferred charges - bond issuance costs 5 Bonds payable 105

17. Discount and premium • Higher risk, higher return expected by investors. • Higher interest rate relative to stated interest rate, lower selling price. • Bonds issued for less (more) than stated value are issued at a discount (premium). • Zero coupon bonds = 0% interest rate, issued at deep discount. • Original discount or premium = discount or premium recorded by issuer.

18. Issuing Bonds w/ Premium or Discount Cash 94 Bond Discount 6 Bonds payable 100 Cash 103 Bonds payable 100 Bond premium 3

19. When a company issues a bond, what is it selling? • Assume a company issues a $1,000, 5%, 10 year bond. Payments are semi-annual. What is the company selling? And what are investors buying? • Interest payments of $25 at the end of each of 20 six-month periods. (An ordinary annuity.) • A lump-sum payment of $1,000 at the end of 10 years.

20. Proceeds of Bond Issue • If the (annual) market rate of interest is 6%, what will proceeds be from the issuance of 4000 bonds: • PV of interest payments (ordinary annuity): • # of bonds* Interest paid per period*PV factor (n,i) • 4000 bonds*$25*14.87748=$1,487,748 • PV of payment at maturity(lump-sum payment) • # of bonds *face*PV factor (n,i) • 4000*$1,000*.553676=$2,214,704 • Total = $1,487,748 + $2,214,704 = $3,702,452

21. Entry to Record Issuance Cash 3,702,452 Bond Discount 297,548 Bonds Payable 4,000,000

22. Book value • Net book value = principal plus unamortized premium or less unamortized discount. • Net carrying amount = book value less unamortized deferred charges (issuance costs).

23. Bond interest expense • 2 components: • Cash interest payments (usually semi-annual). • Amortization of bond premium or discount. • GAAP requires the effective interest rate method of amortization. • SL method allowed only if it does not differ materially from effective interest rate method.

24. Effective interest rate method • = compound interest rate = interest rate (method). • Book value of bonds = market value = cash value, necessarily, only at 2 points in time, when issued (BV = cash received) and at maturity (BV = cash paid).

25. Effective Interest Rate MethodBond Disc. Amortization Table • Beginning book value. • Bonds payable – unamort. Disc. (or + Prem.). • Interest expense. • Beginning book value * effective interest rate. • Interest paid. • Face amount * stated interest rate. • Discount amortization. • Interest expense - interest paid. • Ending book value. • B. payable - new unamort. Disc. (or + Prem.).

26. Retirement of Bonds • Bonds may be callable. A call premium may be required. • Bonds could be purchased in the market and retired. • Gain (loss) = reacquisition price – net carrying amount

27. Leased Assets • Operating leases: • Rent or leases in which payments are expensed. • Capital or financial leases: • Lessee effectively purchases asset. • Use of asset for its economic life is a purchase. • Lease is effectively an installment purchase or a financing tool. • Treated as a purchase of an asset and creation of a liability.

28. Analysis of capital structure • Invested capital = permanent capital = debt capital + equity capital. • Leverage = measure of soundness of company’s financial position. • Debt equity ratio = (total liabilities or non-current liabilities or debt)  Shareholders’ equity. • Debt capitalization ratio = Debt / (Debt + shareholders’ equity). • Times interest earned = interest coverage ratio = Pre-tax income before interest expense / interest expense.

29. Bond Ratings • Indicates probability of going into default (not paying interest or principal as due). • Uses ratios such as debt-equity and other information. • Bond rating agencies include: • Standard & Poor’s. • Moody’s.

30. Discussion Questions • What has more risk: debt or equity capital? • From company point of view? • From investor point of view? • Why do we use the term leverage for the debt-to-equity ratio?

31. 8 End of Chapter 8