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Long-Term Debt and Other Financing Issues. Chapter 22. Loan Payments and Interest. Periodic loan payments consist of two components: Interest expense A portion of the principal balance. Calculating Loan Payments. Periodic Payment =. Amount Borrowed .

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loan payments and interest
Loan Payments and Interest

Periodic loan payments consist of two components:

  • Interest expense
  • A portion of the principal balance
calculating loan payments
Calculating Loan Payments

Periodic Payment =

Amount Borrowed 

Present Value of Annuity Factor Based on the Interest Rate and the Life of the Loan

calculating interest expense
Calculating Interest Expense

Interest Expense =

Book Value of Loan at the Beginning of the Period

Periodic Interest Rate X

calculating repayment of principal
Calculating Repayment of Principal

Repayment of Principal =

Cash payment -

Interest expense

bond characteristics
Bond Characteristics
  • Face Value
  • Maturity date
  • Contract rate
  • Bond certificate
reasons for issuing bonds
Reasons for Issuing Bonds

The main reason for issuing bonds is that the earnings available to the common stockholders can be increased through leverage.

Leverage is the use of borrowing to increase the return to common stockholders. It is also call trading on equity.

use of leverage through bond financing exhibit 22 2
Use of Leverage Through Bond Financing Exhibit 22-2

Before Expansion

Bond Financing

Stock Financing

Earnings before interest and income taxes $100,000 $150,000 $150,000

Interest expense ---- (30,000) ----__

Income before income taxes $100,000 $120,000 $150,000

Income tax expense (40,000) (48,000) (60,000)

Net Income $ 60,000$ 72,000$ 90,000

Number of shares 10,000 10,000 16,000

Earnings per share $6.00 $7.20 $5.63

recording bonds issued at face value
Recording Bonds Issued at Face Value

Cash

Bonds Payable

200,000

200,000

interest expense
Interest Expense

Face Value of Bonds X

(Annual Contract Rate  Number of Interest Payments per Year)

Example:

$200,000 X (10%  2) = $10,000

recording interest expense
Recording Interest Expense

Cash

Interest Expense

10,000

10,000

accrual of interest
Accrual of Interest

Semiannual Interest

X Fraction of Period since Interest Last Paid

Example:

$300,000 X (12%  2) X 4/6 = $12,000

recording interest expense1
Recording Interest Expense

Interest Payable

Interest Expense

12,000

12,000

factors affecting bond interest rates
Factors Affecting Bond Interest Rates
  • The risk-free rate
  • The expected inflation rate
  • The risk premium
slide15

Bonds Issued at Less Than or More Than Face Value

  • Premium - bonds sold when market rate of interest is lower than the contract rate
  • Discount - bonds sold when market rate of interest is higher than the contract rate
  • Yield - the market rate at which the bonds are issued
bonds issued at less than or more than face value
Bonds Issued at Less Than or More Than Face Value

The issuance of bonds sold at a discount or premium is usually quoted as a percentage of the face value.

Face Value X Quoted Percentage = Selling Price

$200,000 X 97% = $194,000

$200,000 X 102% = $204,000

bond interest expense
Bond Interest Expense

Interest Expense for Period =

Book Value at Beginning of Period X Yield

relationship between bond selling prices and interest expense exhibit 22 3
Relationship Between Bond Selling Prices and Interest Expense Exhibit 22-3

Annual Interest Expense Compared to Annual Interest Payment

Yield Compared to Contract Rate

Bonds Sell at

Yield > Contract Rate Discount Interest Expense > Interest Paid

Yield = Contract Rate Face Value Interest Expense = Interest Paid

Yield < Contract Rate Premium Interest Expense < Interest Paid

zero coupon bonds
Zero-Coupon Bonds
  • Bonds pay no interest each period
  • Amount borrowed is less than face value
  • Face value is paid on the maturity date
  • Selling price is the present value of the face value using the annual yield
  • Effective interest method is used for computing yearly interest expense
effective interest method
Effective Interest Method

Selling Price of Bond Issue = Face Value X Present Value Factor

Example:

$1,000,000 X 0.3855 (PV of $1 factor for 10 periods at 10%)

= $385,500

interest expense for zero coupon bonds
Interest Expense for Zero-Coupon Bonds

Interest Expense =

Book value at beginning of period X Annual yield

Example:

$385,500 X 10% = $38,550

recording interest expense2
Recording Interest Expense

Bonds Payable

Interest Expense

Bal. 385,500

38,550

38,550

Bal. 424,050

recording retirement of bonds
Recording Retirement of Bonds

Cash

Bonds Payable

Bal. 198,000

198,000

205,000

Bal. 0

Extraordinary Loss

7,000

evaluation of long term debt and interest expense
Evaluation of Long-Term Debt and Interest Expense
  • Financial flexibility
  • Risk
  • Long-term liquidity
leases
Leases
  • Lease - an agreement giving the right to use property, plant, or equipment without transferring legal ownership
  • Lessee - the company that acquires the right to use the item
  • Lessor - the company that gives up the use of the item
types of leases
Types of Leases
  • Capital Lease - transfers the risks and benefits of ownership from the lessor to the lessee
  • Operating Lease - does not transfer the risks and benefits of ownership
capital lease
Capital Lease

The lessee records an operating asset and a long-term liability at the present value of the lease payments.

Present value of lease payments =

Periodic lease payment

X Present value of annuity factor

recording a capital lease
Recording a Capital Lease

Leased Property

Capital Lease Obligation

15,163

15,163

recording depreciation on leased asset
Recording Depreciation on Leased Asset

Leased Property

Depreciation Expense

Bal. 15,163

3,033

3,033

Bal. 12,130

interest expense for capital leases
Interest Expense for Capital Leases

Interest Expense =

Book value of lease obligation X Interest rate

Example:

$15,163 X 10% = $1,516

reduction of lease obligation
Reduction of Lease Obligation

Reduction of lease obligation =

Cash payment to lessor - Interest expense

Example:

$4,000 - $1,516 = $2,484

recording lease payment
Recording Lease Payment

Cash

Capital Lease Obligation

Bal. 15,163

4,000

2,484

Bal. 12,679

Interest Expense

1,516

mortgage payable
Mortgage Payable

A mortgage payable is a long-term liability for which the lender has a specific claim against an asset of the borrower.

Accounting for a mortgage payable is similar to accounting for a lease obligation.

deferred income taxes
Deferred Income Taxes
  • A temporary difference occurs when a corporation uses different depreciation methods between the accounting records and tax records
  • Deferred Tax Liability - balance sheet account showing future additional income taxes
  • Deferred Tax Asset - balance sheet account showing the amount by which future income taxes will be reduced
retirement benefits
Retirement Benefits
  • Pension plan - an agreement by a company to provide income to its employees after they retire
  • Defined-contribution plan - specifies the amount that the company must contribute to the plan while the employees are working
  • Defined-benefit plan - specifies the amount that the company must pay to its employees during retirement
conclusion
Conclusion

A bond is a type of note in which a company agrees to pay the holder the face value at the maturity date and to pay interest periodically at a specified rate on the face value.

A lease is an agreement giving a company the right to use property, plant, or equipment without transferring legal ownership of the item.

problem 22 23
Problem 22-23

Present Value = Periodic Amount of X Present Value of of annuity annuity Annuity Factor

$10,000 = Periodic Amount of Annuity X 3.4651

Periodic Amount of Annuity = $2,885.92

problem 22 231
Problem 22-23

Beginning Ending Balance InterestPrincipal Balance

1999 $10,000.00 $600.00 $2,285.92 $7,714.08

2000 7,714.08 462.84 2,423.08 5,291.00

2001 5,291.00 317.46 2,568.46 2,722.54

2002 2,722.54 163.38 2,722.54 -0-