FINANCING Part 2: Debt

CHAPTERS 13-16 FINANCING Part 2: Debt

LONG-TERM LIABILITIESFrom Grade 11 • Long-term liabilities are obligations that are expected to be paid after one year. • Long-term liabilities include bonds, long-term notes, and lease obligations.

EFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. Equity • Advantages of Bonds • Shareholder control is not affected. • Income tax savings result. • Earnings per share may be higher.

Disadvantages of Bonds Places cash constraints on the business in the form of: regular interest payments repayment of the Face Value at maturity Since being solvent is crucial, these MANDATORY payments can put a business in a tight pickle. Reported Net Income is lower. observe…. EFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. Equity

EFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. Equity Financing Effects on Accounting Net Income BONDS SHARES Operating Income(Income before interest, taxes, and extraordinary items) $1,500,000 $1,500,000 Interest Expense (7% of 5,000,000) (350,000)4 0 Income before Income Tax 1,150,000 1,500,000 (460,000)2 (600,000) Income Tax Expense (40% of Profit) Net Income $690,0005 $900,000 Shares Outstanding 100,0001 300,000 (200,000 shares @ $25) $3.00 Earnings per share $6.903 PROS: (1) Shareholder control not affected, (2) Income tax is less (3) Earnings per share looks better CONS: (4) Cash constraint in the form of interest payments (5) Lower reported Net Income

EFFECTS OF FINANCING DECISIONSThe Cost of Financing - Debt vs. Equity Note how a 7% before-tax interest CASH cost, turns into a 4.2% after-tax CASH cost. This is because interest expenses are tax deductible, and the lower tax payment means less cash paid out. This means that Financing with debt will produce less accounting PROFIT, but will be cheaper in terms of real CASH. However, debt isn’t always better in terms of less cash paid out. Remember that dividends are OPTIONAL, so there may in fact be NO cash payment with a share issue (though issuing shares raises other concerns). Financing Effects on Cash Flow – NOT Profit BONDS SHARES Funds to be raised 5,000,000 5,000,000 How’s it done? 1. Issue 50 $100,000 7% Bonds, or 5,000,000 2. Issue 200,000 shares at $25 each 5,000,000 Annual Cash Payment Bonds (7% of 5,000,000) MANDATORY 350,000 Shares (7% dividend) OPTIONAL 350,000 Tax savings on interest (40% of $350,000) (140,000) 0 Tax savings on dividends Annual after-tax cost of Financing 350,000 210,000 After-tax cost 7% 4.2%

TYPES OF BONDS • Secured bonds have collateral pledged for the bonds in case of default. • Unsecured bonds are issuedbased on the credit rating of the borrower. (Generally require a higher interest rate).

TYPES OF BONDS • Registered bonds are issued in the name of the owner (interest payments are made by cheque to bondholders on record). • Bearer (or coupon) bonds are not registered; bondholders must send in coupons to receive interest payments. (Rare because vulnerable to theft)

TYPES OF BONDS • Convertible bonds permit bondholders to convert the bonds into common shares at their option. • Redeemable, retractable or callable bondscan be retired early (before maturity) at a stated amount at the option of the issuer or holder.

BOND TERMINOLOGY • The face value is the amount of principal due at the maturity date. • The contractual interest rate or coupon rate, or stated rate, is the rate used to determine interest. • Interest paid is the FACE VALUE x STATED RATE, regardless of the price paid for the bond or prevailing interest rates!!!

THE MARKET VALUE OF BONDS The market value (or Net Present Value - NPV) of any investment is equal to the present value of all the future cash payments it promises. Years 0 1 2 3 4 5 So does that mean that the NPV is just a matter of adding up the cash payments over the years? They look the same. But are they? $100,000 $100,000 Ask yourself, will your $100,000 buy as much now… NO ! NO ! …as it will 5 years from now?

$100,000 $100,000 THE MARKET VALUE OF BONDS • This is because of the time value of money • Inflation (rising prices) changes the value of money (i.e. it changes apples into oranges). • It does this by eroding money’s purchasing power. • Since you can’t add apples and oranges, you can’t add cash flows together over the years either. You must find NPV another way.

THE MARKET VALUE OF BONDS • The market value (NPV or Net Present Value) is a function of three factors: • the cash flows to be received, • the length of time (n) until the amounts are received, and • the market rate of interest (i) which is the rate investors demand for loaning funds to the corporation. • Finding the NPV is referred to as discounting.

THE MARKET VALUE OF BONDSEffect Of Interest Rates On Bond Prices Market Interest Bonds Sell Rates at Bond Contractual Interest Rate of 5% 4% Premium If issued when 5% Face Value 6% Discount

MARKET VALUE OF A BONDPresent Value Calculations (i.e. Discounting) Assume we purchase from the Bond market a $100,000, 10%, 5-year bond. At time of purchase, market interest rates are also 10%. YEAR 0 1 2 3 4 5 Principle: $100,000 $100,000 Interest: $10,000 $10,000 $10,000 $10,000 $10,000 Present Value to Us: $10,000 (1.10)1 $10,000 (1.10)2 $9,091 $10,000 (1.10)3 To do this you must do the following for EVERY stream of Cash in EVERY period: Cash Stream .(1 + Market Interest Rate) Number of years away $10,000 (1.10)4 $8,264 Now you must DISCOUNT the future cash flows that will stream from this Bond to find out what they are currently worth. $110,000 (1.10)5 $7,513 $6,830 $68,302 Can you guess what the total is? $100,000

MARKET VALUE OF A BONDWhen Market Interest Rate Differs Now assume the same bond ($100,000, 10%, 5-year), is bought when the market rate of interest is 12%. YEAR 0 1 2 3 4 5 Principle: $100,000 $100,000 Interest: $10,000 $10,000 $10,000 $10,000 $10,000 Present Value to Us: $10,000 (1.12)1 $10,000 (1.12)2 $8,929 Nothing has changed, the discounting formula is the same: Cash Stream .(1 + Market Interest Rate) Number of years away $7,972 $7,118 $6,355 $62,417 Why? A Disount! Can you guess what the total is now? $92,790

Present value of $100,000 received in 5 periods $100,000 x 0.56743 (Table B-1: n=5, i=12%) $ 56,743 Present value of $10,000 received annually for 5 periods $10,000 x 3.60478 (Table B-2: n=5, i=12%) 36,047 Present (market) value of bonds $92,790 CALCULATING THE PRESENT VALUE OF BONDS • The easiest way to value a bond is using annuity and present value tables (they appear in the back of your text). Click for Excel File

Do Handouts:

ACCOUNTING FOR BOND ISSUES NOTE: Once again, I recommend you start a fresh page and make a chart in your notes like this one (leave enough space for a journal entry in each section): 1. Face Value 2. Discount 3. Premium Bond Issue Interest Payment Recall Bonds may be issued at: • Face value • Discount (below face value), or • Premium (above face value).

Date Particulars Debit Credit Jan 1 FACE VALUEBond Issue • On January 1st of this year, we issued a $100,00012%5-year note. • Market interest rates were 12% Cash 100,000 Bonds Payable 100,000 To record issue of Bonds at face value.

Dec 31 Date Particulars Debit Credit FACE VALUEInterest Payment On December 31st, the following journal entry would be made: Bond Interest Expense 12,000 Cash 12,000 To record payment of bond interest.

Feb 1 Date Particulars Debit Credit FACE VALUERecall On February 1st of the SECOND YEAR, we recall the bond for $100,000. Bonds Payable 100,000 Interest Expense 1,000 Cash 101,000 To recall the bond.

Jan 1 Date Particulars Debit Credit 2. DISCOUNTBond Issue • On January 1, we sell $100,000, 12%, 5-year, bonds at 93.134 (93.134 percent of face value). • The market interest rate was 14% at the time. Cash 93,134 Discount on Bonds Payable 6,866 Bonds Payable 100,000 To record issue of Bonds payable at a discount.

BEFORE WE MOVE ON:Amortizing Bond Discounts and Premiums • Due to the matching principle, a bond discount/premium should be amortized over the life of the bond (just as interest is). • The method used is straight-line. • The text discusses another method; IGNORE IT.

Bond Discount Number of Interest Periods Bond Discount Amortization  = STRAIGHT-LINE METHOD OF BOND DISCOUNT AMORTIZATION

Dec 31 Date Particulars Debit Credit 2. DISCOUNTInterest Payment The entry to record interest on December 31st is: NOTE: Over the term of a bond, the balance in a Discount OR Premium will decrease annually by the same amount until it reaches zero at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds. Interest Expense 13,373 Discount 1,373 Cash 12,000 To record interest payment for first year’s interest.

2. DISCOUNTStatement Presentation Long-term liabilities Bonds payable Less: Discount on bonds payable $ 100,000 (5,493) $94,507 • The $94,507 represents the carrying(or book) value of the bonds. • On the date of issue, this amount equals the market price of the bonds $93,134. • On the date of maturity carrying value equals face value ($100,000).

EARLY BOND RETIREMENTS • Bonds may be redeemed before maturity because a company may decide to reduce interest cost and remove debt from its balance sheet. • Similar to disposing of an asset, when bonds are retired before maturity you must: • Update interest to date of disposal, • Eliminate all accounts associated with the Bond (including discounts and premiums) • Record the cash paid, and • Recognize a gain or loss on redemption and report as extraordinary in the income statement.

Feb 1 Feb 1 Date Date Particulars Particulars Debit Debit Credit Credit 2. (Back to it) DISCOUNTRecall The entry to recall the Bond for $100,000 on Feb 1st of YEAR TWO is: Interest Expense 1,114 Bond Discount 114 Cash 1,000 To record interest up to date for disposal. Bonds Payable 100,000 Loss on Recall of Bonds 5,379 Bond Discount 5,379 Cash 100,000 To dispose of the bond.

Jan 1 Date Particulars Debit Credit 3. PREMIUMBond Issue We issued a $100,000, 12%, 5-year Bond on January 1st. Market interest rates are 10%. Cash 107,582 Premium on Bonds 7,582 Bonds Payable 100,000 To record issue of bonds with a premium.

Dec 31 Date Particulars Debit Credit 3. PREMIUMInterest Payment To record the interest at the end of the FIRST YEAR, we make the following entry: Interest Expense 10,484 Bond Premium 1,516 Cash 12,000 To record issue of bonds with a premium.

STATEMENT PRESENTATION OF BONDS PREMIUM Long-term liabilities Bonds payable Add: Premium on bonds payable $100,000 6,066 $106,066 The $106,066 represents the carrying(or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds. At maturity it will equal the face value ($100,000).

Feb 1 Feb 1 Date Date Particulars Particulars Debit Debit Credit Credit 3. (Back to it) PREMIUMRecall The entry to recall the Bond for $100,000 on Feb 1st of YEAR TWO is: Interest Expense 876 Bond Premium 126 Cash 1,000 To record interest up to date for disposal. Bonds Payable 100,000 Bond Premium 5,940 Gain on Recall of Bonds 5,940 Cash 100,000 To dispose of the bond.

MORTGAGES • Mortgage notes payable are widely used in the purchase of homes by individuals and in the acquisition of capital assets by many small and some large companies. • They differ from bonds in that some of the Principle (face value) is repaid each month with the interest payment. • Mortgages are like secured bonds in that they have collatoral.

MORTGAGE NOTES PAYABLE • Mortgage notes payable are recorded at face value and entries are required subsequently for each installment. • To record interest • To reduce the principle • On the balance sheet, the portion of principle for the next 12 months is reported as a current asset (current portion of mortgage payable). • The rest of the mortgage is classified as a long-term liability.

Total Debt Total Assets Debt to Total Assets   DEBT TO TOTAL ASSETS The debt-to-total-assets ratioindicates the percentage of total assets owed to creditors, providing one measure of leverage. It is calculated by dividing total debt by total assets.

Net Income + Interest Expense + Income Tax Expense Interest Expense Times Interest Earned   TIMES INTEREST EARNED The times interest earnedmeasures the company’s ability to meet interest payments as they come due. It is calculated by dividing income before interest expense and income tax expenseby interest expense.

FINANCING Part 2: Debt