Fundamental Financial Accounting Concepts Fourth Edition by Edmonds, McNair, Milam, Olds

1
Fundamental Financial Accounting ConceptsFourth
EditionbyEdmonds, McNair, Milam, Olds

• PowerPoint presentation by
• J. Lawrence Bergin

2
Chapter 10

• Accounting for Debt Transactions

LOANS BONDS
3
Business Background

• Capital structure is the mix of debt and equity
  used to finance a company.
• Loans from banks, insurance companies, or pension
  funds are often used when borrowing small amounts
  of capital.
• Bonds are debt securities issued when borrowing
  large amounts of money.
• Can be issued by either corporations or
  governmental units.

4
Business Background

• Capital structure is the mix of debt and equity
  used to finance a company.
• Loans from banks, insurance companies, or pension
  funds are often used when borrowing small amounts
  of capital.
• Bonds are debt securities issued when borrowing
  large amounts of money.
• Can be issued by either corporations or
  governmental units.

5
Financial Analysis

• The debt-to-equity ratio is an important measure
  of the state of a companys capital structure.

Debt-to-Equity Ratio Total Liab. Total Equity

• When a companys debt-to-equity
• ratio is excessive, a large amount of
• fixed debt payments may cause
• problems in tight cash flow periods.

6
Loans Long-term Notes Payable

• Most long-term notes require period payments.
• The note is repaid in equal installments, part of
  which are repayment of principal and part of
  which are interest.

7
Example Borrowing on Long-term Note Payable

• ABC Co. signed a 100,000, 3 year Note Payable
  which carried an 8 annual interest rate.
  Payments are to be made annually on December 31
  of each year for 38,803.35.
• What is the amount of the liability (Note
  payable) after the first payment is made?

8
Example continued...

• For Yr.1, the outstanding amount borrowed is
  100,000 (at 8), so the interest is
• 8,000
• Payment is 38,803.35, so the amount that will
  reduce the principal is
• 30,803.35 38,803.35-8,000
• New outstanding principal amount is
• 100,000 - 30,803.35 69,196.65

9
Amortization schedule

• A B C D
• Principal Payment Interest Prin. Repaid
• Prev. bal. - D Given .08 X A (B - C)
• 100,000.00 38,803.35 8,000.00
  30,803.35
• 69,196.65 38,803.35 5,535.73
  33,267.62
• 35,929.03 38,803.35 2,874.32
  35,929.03
• 0.00
• 69,196.65 x .08
• 38,803.35 - 5,535.73 33,267.62
• 69,196.65 - 33,267.62 35,929.03

1 2 3
10
Horizontal Model
11
Journal Entries for Note Payable Example
12
Loans Long-term Mortgages

• A mortgage is a special kind of note
  payable--one issued for property (land,
  buildings).
• It is repaid in equal installments, part of which
  are repayment of principal and part of which are
  interest.

13
How buying an asset using a mortgage is reflected
in the financial statements

• Journal entry when the mortgage is issued
• Debit LAND or BLDG.
• Credit Mortgage Payable
• Journal entry to make a payment
• Debit Interest expense
• Debit Mortgage Payable
• Credit Cash.

City National Bank
14
Characteristics of Bonds Payable

• Bonds usually involve the borrowing of a large
  sum of money, called principal, for a fairly long
  time period.
• The principal is usually paid back as a lump sum
  at the end of the bond period.
• Individual bonds are often denominated with a par
  value, or face value, of 1,000.

15
Characteristics of Bonds Payable
To make them quicker and easier, all bond
illustrations presented here will have very short
terms and small principals.
16
Characteristics of Bonds Payable

• Bonds usually carry a stated rate of interest.
• Interest is normally paid semiannually.
• Interest is computed as

Interest Principal Stated Rate Time
3M Bond
17
Characteristics of Bonds Payable

• The new bondholder receives a bond certificate.
• Identifies the par value, the stated interest
  rate, the interest dates, and the maturity date.
• The trustee makes sure the issuing company
  fulfills all of the provisions of the bond
  indenture, or agreement.

18
Bond Classifications

• Unsecured bonds (also called debentures) do not
  have pledged assets as a guarantee of repayment
  at maturity.
• Secured bonds include a pledge of specific assets
  as a guarantee of repayment at maturity.

19
Bond Classifications

• Ordinary bonds (also called single-payment bonds)
• The full face amount is paid at the maturity.
• Serial bonds
• The principal is paid in installments on a series
  of specified maturity dates.

20
Bond Classifications

• Callable bonds
• May be retired and repaid (called) at any time at
  the option of the issuer.
• Redeemable bonds
• May be turned in at any time for repayment at the
  option of the bondholder.
• Convertible bonds
• May be exchanged for other securities of the
  issuer (usually shares of common stock) at the
  option of the bondholder.

21
Bond Classifications

• Registered bonds
• Payment of interest is made by check and mailed
  directly to the bondholder whose name must be
  registered.

• Coupon bonds
• Coupons are attached to the
  bond for each interest payment.
• The bondholder clips each coupon
  and presents it for payment on the
  interest date.

Bond
Interest COUPON
22
Measuring Bonds Payable and Interest Expense

• The selling price of the bond is determined by
  the market based on the time value of money.
• today future

Bonds issued
. . .
principal payment
dates of interest payments
.
23
The time value of money...

• Selling price of a bond
• present value of future cash flows promised by
  the bonds, discounted using the market rate of
  interest

The Appendix to this chapter shows how to make
Present Value calculations.
24
Measuring Bonds Payable and Interest Expense

• The interest rate used to compute the present
  value is the market interest rate.
• Also called yield, effective rate, or true rate.
• Creditors demand a certain rate of interest to
  compensate them for the risks related to bonds.
• The stated rate, or coupon rate, is only used to
  compute the periodic cash interest payments.

25
Determining the Selling Price

• Bonds sell at
• Par (100 of face value)
• less than par (discount)
• more than par (premium)
• Market (or effective) rate of interest vs.
  bonds stated rate of interest determines the
  selling price (or market or issue price of the
  bond).

26
Determining the Selling Price

• Selling price Present value of future cash
  flows promised by the bonds, using market rate
  for present-value calculations. (The Appendix
  demonstrates these calculations.)
• Therefore, if
• market stated Discount
• market
• market stated Face or par

27
Selling Bonds - Example

• On Jan. 2, 2004, CeeDees Corp. sells 100,000 in
  bonds having a stated rate of 7 annually. The
  bonds mature in 3 years, and interest is paid
  semi-annually. The market rate is 10 annually.

Determine whether the bonds sell at par, at a
discount, or at a premium.
28
Selling Bonds - Example

• On Jan. 2, 2004, CeeDees Corp. sells 100,000 in
  bonds having a stated rate of 7 annually. The
  bonds mature in 3 years, and interest is paid
  semi-annually. The market rate is 10 annually.

These bonds would sell at a discount. Investors
are demanding a 10 return. These bonds are
only paying 7 interest. So, investors wont
buy them unless the price is reduced that is,
sold at a DISCOUNT.
29
Selling Bonds - Example

• Until recently, bond selling prices were always
  quoted as a whole number with a fraction such as
  922/5. Now decimals are used instead of
  fractions. So, the bond above would be quoted as
  92.400 in the bond market.
• What does that mean?
• The bonds sold for 92.400 of their face (par)
  value.
• Proceeds 92,400 for 100,000 face bonds.
  (100,000 x .924 92,400)

30
Recording Bonds Sold at a Discount

• Prepare the journal entry to record the sale of
  the bonds.

Cash
Discount on Bonds Payable Bonds
Payable
31
Recording Bonds Sold at a Discount

• Prepare the journal entry to record the sale of
  the bonds.

Cash
Discount on Bonds Payable Bonds
Payable-face 100,000
32
Recording Bonds Sold at a Discount

• Prepare the journal entry to record the sale of
  the bonds.

Cash
92,400 Discount on Bonds Payable
Bonds Payable-face 100,000
33
Recording Bonds Sold at a Discount

• Prepare the journal entry to record the sale of
  the bonds.

Cash
92,400 Discount on Bonds Payable 7,600
Bonds Payable-face 100,000
This is a contra-liability account and appears in
the liability section of the balance sheet
as a SUBTRACTION from the
Bonds Payable-face amount.
34
Measuring and Recording Interest on Bonds Issued
at a Discount

• The discount must be amortized over the
  outstanding life of the bonds.
• The discount amortization increases the periodic
  interest expense for the issuer.
• Although the Effective Interest method is
  required by GAAP, the easier Straight-line
  method will be used for these examples.
• The Effective Interest amortization method is
  explained in the Appendix)

35
Straight-Line Amortization of Bond Discount

• Identify the amount of the bond discount.
• Divide the bond discount by the number of
  interest periods.
• Include the discount amortization amount as part
  of the periodic interest expense entry.
• The discount will be reduced to zero by the
  maturity date.

36
Straight-Line Amortization of Bond Discount

• CeeDees Corp. sold their bonds on Jan. 2, 2004 at
  92.400. The bonds have a 3-year maturity and
  3,500 interest is paid semiannually (that is,
  each six months).
• Why would the bonds sell for 92.400?
• The 10 market rate of interest is greater than
  the 7 stated rate on the bond face. So,
  investors wont buy them unless the price is
  reduced.
• Where did the 3,500 come from?
• 100,000 face x .07 x 1/2 yr.

37
Straight-Line Amortization of Bond Discount

• Prepare the journal entry to record the payment
  of interest and the discount amortization for the
  six months ending on June 30, 2004.

Interest Expense Discount on
Bonds Payable
Cash
38
Straight-Line Amortization of Bond Discount

• Prepare the journal entry to record the payment
  of interest and the discount amortization for the
  six months ending on June 30, 2004.

Interest Expense Discount on
Bonds Payable
Cash 3,500
100,000 Face x .07 stated rate x 1/2 yr.
3,500 for 6 mos.
39
Straight-Line Amortization of Bond Discount

• Prepare the journal entry to record the payment
  of interest and the discount amortization for the
  six months ending on June 30, 2004.

Interest Expense Discount on
Bonds Payable 1,267
Cash 3,500

7,600 Disc. 6 interest periods 1,267
each 6 months
40
Straight-Line Amortization of Bond Discount

• Prepare the journal entry to record the payment
  of interest and the discount amortization for the
  six months ending on June 30, 2004.

Interest Expense 4,767 Discount
on Bonds Payable 1,267
Cash 3,500
Which amount appears on the Income
Statement? 4767 (the effective interest
expense) Which amount appears on the Cashflow
Statement? 3,500 Operating Activity outflow for
cash paid
41
Straight-Line Amortization of Bond Discount

• Prepare the journal entry to record the payment
  of interest and the discount amortization for the
  six months ending on June 30, 2004.

Interest Expense 4,767 Discount
on Bonds Payable 1,267
Cash 3,500
Note that the existence of a DISCOUNT causes the
Effective Interest EXPENSE to be GREATER THAN the
CASH interest actually paid to the bondholders.
42
Straight-Line Amortization of Bond Discount

• This exact journal entry will be made each six
  months for the three year term of the bond. At
  the end, the balance of the Discount on Bonds
  Payable account will be 0.

Interest Expense 4,767 Discount
on Bonds Payable 1,267
Cash 3,500
43
Horizontal Model

• Record the issue of CeeDee Corp. bonds on 1/1/04.
• Record the Interest payments at the end of
• Period 1 6/30/04
• Period 2 12/31/04
• Period 3 6/30/05
• Period 4 12/31/05
• Period 5 6/30/06
• Period 6 12/31/06
• Record the principal repayment at maturity
  12/31/06.

44
Horizontal Model Transaction Analysis
10- 44
Record issuance of CeeDees bonds, all interest
payments, and final repayment of the bonds at
maturity.
Balance Sheet
Income Statement Cashflow

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./- Exp./
• Pay-par Disc. Prem.
  Gain- Loss N.I. OA,IA,FA

P e r
0 1 2 bal
C Income Statement accounts closed to 0.
0 0 0 3 4 bal
C Income Statement accounts closed to 0.
0 0 0
5 6 end bal
45
Horizontal Model Transaction Analysis
10- 45
Record the Issue of the CeeDee Corp. bonds on
1/1/04. Record Interest expense for the first
2 periods.
Balance Sheet
Income Statement Cashflow

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./ - Exp./
• Pay-par Disc. Prem.
  Gain - Loss N.I. OA,IA,FA

P e r
0 92400 100000 7600

92400 FA 1 (3500) (1267)
(4767) 4767 (4767)
(3500)OA 2 (3500) (1267)
(4767) 4767 (4767)
(3500)OA bal 85400 100000 5066
(9534) 9534 (9534) 85400
bal
How much Interest Expense is on the 2004 Inc.
Statement? 9,534 (4,767 4,767) How
much interest will be on the 2004 Cashflow
Statement? 7,000 (3,500 3,500) What is
the bond Carrying Value on the 12/31/04 Bal.
Sheet? First, lets discuss what Bond
Carrying Value means.
46
Carrying value of BONDS PAYABLE

• While the specific long-term liability, Bonds
  Payable, is always recorded (and kept) at face
  value, the remaining balance (called the
  Unamortized balance) of the Discount or Premium
  will be either subtracted (if discount) or added
  (if premium) to the B/P-face amount to get the
  carrying value also called book value of the
  bonds at any given date.

47
Carrying value of BONDS PAYABLE
The December 31, 2004 CeeDees Corp. Balance Sheet
will report the bonds at their Carrying
Value Long-term Liability section Bonds
Payable-face 100,000 Less Unamortized
Discount ( 5,066) Total Bond Liability
(Carrying V.) 94,934
Lets return to the horizontal model.
48
Horizontal Model Transaction Analysis
10- 48
Recording Year 1 transactions for CeeDee
Corp. bonds
Balance Sheet
Income Statement Cashflow

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./ - Exp./
• Pay-par Disc. Prem.
  Gain - Loss N.I. OA,IA,FA

O
P e r
0 92400 100000 7600

92400 FA 1 (3500) (1267)
(4767) 4767 (4767)
(3500)OA 2 (3500) (1267)
(4767) 4767 (4767)
(3500)OA bal 85400 100000 5066
(9534) 9534 (9534) 85400
bal
Bond Liability Bond Payable-face
100,000 Less Unamortized Discount 5,066
Bond Carrying Value 94,934
49
Horizontal Model Transaction Analysis
10- 49
Assuming the 2004 closing entries were made,
record the two 2005 interest expense
transactions.
Balance Sheet
Income Statement Cashflow

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./- Exp./
• Pay-par Disc. Prem.
  Gain - Loss N.I. OA,IA,FA

P e r
0 92400 100000 7600

92400 FA 1 (3500) (1267)
(4767) 4767 (4767)
(3500)OA 2 (3500) (1267)
(4767) 4767 (4767)
(3500)OA bal 85400 100000 5066
(9534) 9534 (9534) 85400
bal
C Income Statement accounts closed to 0.
0 0 0 3 (3500)
(1267) (4767)
4767 (4767) (3500)OA 4 (3500)
(1267) (4767)
4767 (4767) (3500)OA bal 78400 100000 2532
(19,068) 9534
(9534) 78,400bal
C Income Statement accounts closed to 0.
0 0 0
50
Horizontal Model Transaction Analysis
10- 50
Record the two 2006 interest expense
transactions, and Record the repayment of
principal on Dec. 31, 1906.
Balance Sheet
Income Statement Cashflow

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./ - Exp./
• Pay-par Disc. Prem.
  Gain - Loss N.I. OA,IA,FA

P e r
0 92400 100000 7600

92400 FA 1 (3500) (1267)
(4767) 4767 (4767)
(3500)OA 2 (3500) (1267)
(4767) 4767 (4767)
(3500)OA bal 85400 100000 5066
(9534) 9534 (9534) 85400
bal
C Income Statement accounts closed to 0.
0 0 0 3 (3500)
(1267) (4767)
4767 (4767) (3500)OA 4 (3500)
(1267) (4767)
4767 (4767) (3500)OA bal 78400 100000 2532
(19068) 9534
(9534) 78400 bal
C Income Statement accounts closed to 0.
0 0 0
5 (3500) (1267)
(4767) 4767 (4767)
(3500)OA 6 (3500) (1265) (2
less-rounding) (4765) 4765
(4765) (3500)OA end(100000)(100000)
(100000)FA bal (28600) 0 0
(28600) 9532 (9532)
(28600) B
51
Selling Bonds - Example

• On Jan. 2, 2004, Blimp, Inc. sells 100,000 in
  bonds having a stated rate of 10 annually. The
  bonds mature in 3 years and interest is paid
  semiannually. The market (effective, or yield)
  rate is 8 annually.

Determine whether the bonds sell at par, at a
discount, or at a premium.
52
Selling Bonds - Example

• To figure out the proceeds from the sale, you
  either have to calculate the present value of the
  payments (using the market rate of interest)
• OR
• Be told that the bonds sold at 105.250

53
Recording Bonds Sold at a Premium

• Prepare the journal entry to record the issuance
  of the bonds.

Cash Bonds Payable -
face Premium on Bonds Pay.
54
Recording Bonds Sold at a Premium

• Prepare the journal entry to record the issuance
  of the bonds.

Cash Bonds Payable - face
100,000 Premium on Bonds Pay.
55
Recording Bonds Sold at a Premium

• Prepare the journal entry to record the issuance
  of the bonds.

Cash 105,250 Bonds Payable -
face 100,000 Premium on Bonds Pay.
56
Recording Bonds Sold at a Premium

• Prepare the journal entry to record the issuance
  of the bonds.

Cash 105,250 Bonds Payable -
face 100,000 Premium on Bonds Pay.
5,250
This is called an adjunct account and appears in
the liability section as an addition to the Bond
Payable-face liability.
57
Measuring and Recording Interest on Bonds Issued
at a Premium

• The premium must be amortized over the term of
  the bonds.
• (Again, GAAP requires the Effective Interest
  method, but well use the Straight-line method
  here.)
• The premium amortization decreases the periodic
  interest expense for the issuer.

58
Straight-Line Amortization of Bond Premium

• Identify the amount of the bond premium.
• Divide the bond premium by the number of interest
  periods.
• Include the premium amortization amount as part
  of the periodic interest expense entry.
• The premium will be reduced to zero by the
  maturity date.

59
Straight-Line Amortization of Bond Premium

• Prepare the journal entry to record the payment
  of interest and the premium amortization for the
  six months ending on June 30, 2004.

Interest Expense Premium on Bonds
Payable Cash
60
Straight-Line Amortization of Bond Premium

• Prepare the journal entry to record the payment
  of interest and the premium amortization for the
  six months ending on June 30, 2004.

Interest Expense Premium on Bonds
Payable Cash 5,000
100,000 x .10 x 1/2 5,000
61
Straight-Line Amortization of Bond Premium

• Prepare the journal entry to record the payment
  of interest and the premium amortization for the
  six months ending on June 30, 2004.

Interest Expense Premium on Bonds
Payable 875 Cash 5,000
5,250 6 periods 875 each six months.
62
Straight-Line Amortization of Bond Premium

• Prepare the journal entry to record the payment
  of interest and the premium amortization for the
  six months ending on June 30, 2004.

Interest Expense 4,125 Premium on Bonds
Payable 875 Cash 5,000
The existence of a Premium causes the EFFECTIVE
interest expense (4,125) to be lower than the
CASH interest paid (5,000).
63
Straight-Line Amortization of Bond Premium

• Prepare the journal entry to record the payment
  of interest and the premium amortization for the
  six months ending on June 30, 2004.

Interest Expense 4,125 Premium on Bonds
Payable 875 Cash 5,000
This exact same entry will be made at the end of
each six months throughout the three year term of
the bond.
64
Horizontal Model Transaction Analysis
10- 64
Record the issue of the Blimp Corp. bonds on
1/1/04, and the Interest expense for the
first 2 periods.
Balance Sheet
Income Statement Cashflow

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./ - Exp./
• Pay-par Disc. Prem.
  Gain - Loss N.I. OA,IA,FA

P e r
0 105250 100000 5250

105250FA 1 (5000)
(875) (4125) 4125 (4125)
(5000) OA 2 (5000)
(875) (4125) 4125 (4125)
(5000) OA bal 95250 100000 3500
(8250) 8250 (8250)
95250 bal
How much Interest Expense is on the 2004 Inc.
Statement? 8,250 (4,125 4,125) How
much interest will be on the 2004 Cashflow
Statement? 10,000 (5,000 5,000) What
is the bond Carrying Value on the 12/31/04 Bal.
Sheet?
65
Horizontal Model Transaction Analysis
10- 65
Record the issue of the Blimp Corp. bonds on
1/1/04, and the Interest expense for the
first 2 periods.
Balance Sheet
Income Statement Cashflow
Long-term Liabilities Bond Payable-face 100,000
Plus Unamortized Prem. 3,500 Bond
Carrying Value 103,500

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./ - Exp./
• Pay-par Disc. Prem.
  Gain - Loss N.I. OA,IA,FA

O
P e r
0 105250 100000 5250

105250FA 1 (5000)
(875) (4125) 4125 (4125)
(5000) OA 2 (5000)
(875) (4125) 4125 (4125)
(5000) OA bal 95250 100000 3500
(8250) 8250 (8250)
95250 bal
How much Interest Expense is on the 2004 Inc.
Statement? 8,250 (4,125 4,125) How
much interest will be on the 2004 Cashflow
Statement? 10,000 (5,000 5,000) What
is the bond Carrying Value on the 12/31/04 Bal.
Sheet?
103,500
66
Understanding Notes to Financial Statements

• Effective-interest method of amortization is
  required by GAAP. (This method is in the
  Appendix.)
• Straight-line amortization may be used if it is
  not materially different from effective interest
  amortization.
• Most companies do not disclose the method used
  for bond interest amortization.

67
Early Retirement of Debt

• When a bondholder (the investor) sells a bond
  that is already on the market, there is no
  effect on the books of the issuing company.
• Occasionally, the issuing company will call
  (repay early) some or all of its bonds.

68
Calling a bond...

• If the bond is callable, the issuer may decided
  to call the bond (retire it before maturity).
• The liability and any remaining premium or
  discount would be removed from the books.
• The difference between cash paid and Carrying
  value on that date is recorded as an income
  statement Gain (cash paid paid CV).

69
Early Retirement of Debt

• Bonds can be retired by exercising a call
  provision on the bond, or by purchasing the bond
  on the open market.
• Any gains or losses incurred as a result of
  retiring the bonds should be reported as an
  extraordinary item in the lower portion of the
  income statement.

70
Ex Early Retirement of Debt
What if the Blimp Corp. called their bonds at the
end of year 1? The bonds had a Call Provision
requiring the company to pay 104 to call the
bonds.
Bonds Payable - face 100,000 Unamortized
Premium 3,500 Carrying Value on
12/31/04 103,500 Cash paid to Call bonds
104,000 Loss on Bond Retirement 500
The 500 loss is reported as an Extraordinary
item on Inc. Statement.
71
Horizontal Model Transaction Analysis
10- 71
Record the CALL of the Blimp Corp. bonds on
12/31/04.
Balance Sheet
Income Statement Cashflow

• Assets Liab.
  Equity Statement
• Cash Bond - Bond Bond C.C. R.E.
  Rev./ - Exp./
• Pay-par Disc. Prem.
  Gain - Loss N.I. OA,IA,FA

P e r
0 105250 100000 5250

105250FA 1 (5000)
(875) (4125) 4125
(4125) (5000) OA 2 (5000)
(875) (4125) 4125
(4125) (5000) OA B 95250 100000
3500 (8250) 8250
(8250) 95250 bal
C (104000) (100000) (3500)
(500) 500 (500) (104000)FA
.
72
Bond Sinking Funds

• A special fund to be used to retire bonds at
  maturity.
• Normally, periodic cash contributions are made to
  the fund.
• Usually reported on the balance sheet as a
  non-current (investment) asset.

73
Ratio Analysis
Times-interest-earned Ratio Indicates the
borrowers ability to meet fixed interest payments
EBIT Times Interest
Earned Interest Expense
EBIT Earnings Before Interest and Taxes
Higher ratio is better indicates less risk of
default.
74
Ratio Analysis
Times-interest-earned Ratio
Example Sales 100 Operating Expenses (
70) Earnings before Interest and Taxes
30 Interest Expense (10) Income before
Taxes 20 Income taxes (6) Net
Earnings 14
EBIT Interest Expense
30 10
3 times
Your financial future is
cloudy!
75
Debt vs. Equity Financing
Financing with debt Interest payments are tax
deductible. Financing with Equity (additional
owners capital investment) Distributions to
owners (Dividends) are NOT tax
deductible.
76
Debt vs. Equity Financing
Financing with debt Interest payments MUST BE
PAID even if the company is losing
money. Financing with Equity (additional owners
capital investment) Distributions to owners
(Dividends) could
be reduced or eliminated in bad times.
77
Debt vs. Equity Financing
Matts of Milton, Inc. must raise 1,000,000 to
finance an expansion project. Two options are
being considered.
Option 1 Issue 10 year, 5 annual rate bonds at
100.
Option 2 Attract new ownership investors by
issuing 20,000 new ownership shares at 50 each.
Current owners, holding 10,000 shares, will
expect to continue receiving their 2.50 per
share annual cash dividend distribution.
78
Debt vs. Equity Financing
Use Equity Use Debt
Sales Revenue (forecasted) Operating Exp (80 x
sales) Earnings before Interest Taxes Interest
Exp. (1,000,000 x .05) Income before
taxes Income taxes (40) Net Income 2.50
Dividend on Orig. 10,000 sh. 2.50 Dividend on
Extra 20,000 sh. Addition to Retained Earnings
1,000,000 (800,000) 200,000
- 200,000 (80,000)
120,000 (25,000) (50,000) 45,000
1,000,000 (800,000) 200,000
(50,000) 150,000 60,000) 90,000
(25,000) - 65,000
79
Debt vs. Equity Financing
Use Equity Use Debt
Although interest is 50,000 more, Net Income is
only 30,000 less because 20,000 less TAXES were
paid.
Sales Revenue Operating Exp (80 x
sales) Earnings before Interest Taxes Interest
Exp. (1,000,000 x .05) Income before
taxes Income taxes (40) Net Income 2.50
Dividend on Orig. 10,000 sh. 2.50 Dividend on
Extra 20,000 sh. Addition to Retained Earnings
1,000,000 (800,000) 200,000
- 200,000 (80,000)
120,000 (25,000) (50,000) 45,000
1,000,000 (800,000) 200,000
(50,000) 150,000 60,000) 90,000
(25,000) - 65,000
80
Debt vs. Equity Financing
Use Equity Use Debt
There is NO tax savings on the additional 50,000
in cash dividends paid on the new shares of stock
issued to raise the 1,000,000.
Sales Revenue Operating Exp (80 x
sales) Earnings before Interest Taxes Interest
Exp. (1,000,000 x .05) Income before
taxes Income taxes (40) Net Income 2.50
Dividend on Orig. 10,000 sh. 2.50 Dividend on
Extra 20,000 sh. Addition to Retained Earnings
1,000,000 (800,000) 200,000
- 200,000 (80,000)
120,000 (25,000) (50,000) 45,000
1,000,000 (800,000) 200,000
(50,000) 150,000 60,000) 90,000
(25,000) - 65,000
81
Debt vs. Equity Financing
Use Equity Use Debt
Although 50,000 is paid annually to obtain the
1,000,000 financing, the debt financing
increases Retained Earnings by an extra 20,000.
Because the interest is tax deductible the
20,000 tax savings (50,000 x 40) stays in the
company to the benefit of the owners.
Sales Revenue Operating Exp (80 x
sales) Earnings before Interest Taxes Interest
Exp. (1,000,000 x .05) Income before
taxes Income taxes (40) Net Income 2.50
Dividend on Orig. 10,000 sh. 2.50 Dividend on
Extra 20,000 sh. Addition to Retained Earnings
1,000,000 (800,000) 200,000
- 200,000 (80,000)
120,000 (25,000) (50,000) 45,000
1,000,000 (800,000) 200,000
(50,000) 150,000 60,000) 90,000
(25,000) - 65,000
82
Debt vs. Equity Financing
Use Equity Use Debt
Equity transactions and Earnings per share (EPS)
are the subject of the next chapter. But notice
here that if the equity option is chosen there
are more owners with whom the current owners will
have to share all future profits. That reduces
the Earnings (profit) per share of ownership.
Sales Revenue Operating Exp (80 x
sales) Earnings before Interest Taxes Interest
Exp. (1,000,000 x .05) Income before
taxes Income taxes (40) Net Income 2.50
Dividend on Orig. 10,000 sh. 2.50 Dividend on
Extra 20,000 sh. Addition to Retained Earnings
1,000,000 (800,000) 200,000
- 200,000 (80,000)
120,000 (25,000) (50,000) 45,000
1,000,000 (800,000) 200,000
(50,000) 150,000 60,000) 90,000
(25,000) - 65,000
In this case the use of debt is an effective use
of leverage. It improves the return to the
owners as shown by the higher EPS for the debt
financing option.
Earnings per share N. Inc./ sh. 4.00
9.00 120,000/30,000sh4
90,000/10,000sh9
83
This ends the main part of Chapter 10.There is a
Ready Shows Appendix that covers the following
topics

• Introduction to Present Value and Future Value -
  Basic Principles
• - Using P.V. to calculate loan payments
• - Using F.V. to calculate Bond Sinking Fund
  payments
• - Using P.V. to calculate a Bonds selling
  price
• The Effective Interest Method of Premium and
  Discount Amortization
• Bonds sold with Accrued Interest.

84
Chapter 10
The Appendix follows.