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Chapter

8
Sources of Capital: Debt

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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.

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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.

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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.

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

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

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Levels of likelihood/GAAP
Probable
Reasonably estimated/Accrue. Not reasonably estimated/Disclose

Reasonably possible/Disclose Remote/No accrual; no disclosure.

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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.
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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).

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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.


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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.
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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.

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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.


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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.
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Accounting for Bonds


Issuance at par - no issuance costs Cash 100 Bonds payable 100

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Issuance at par - with issuance costs


Cash 100 Deferred charges bond issuance costs 5 Bonds payable 105

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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.


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Issuing Bonds w/ Premium or Discount


Cash Bond Discount Bonds payable Cash Bonds payable Bond premium 94 6 100 103 100 3
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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.

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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


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Entry to Record Issuance


Cash Bond Discount Bonds Payable 3,702,452 297,548 4,000,000

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

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Bond interest expense


2 components:
Cash interest payments (usually semiannual). 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.
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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).

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Effective Interest Rate Method Bond 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.).
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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

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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.
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Analysis of capital structure


Invested capital = permanent capital = debt capital + equity capital. Leverage = measure of soundness of companys 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.
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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 & Poors. Moodys.

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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?

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