Debt vs Equity

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Debt vs Equity

• SFAS 150 Accounting for Certain Financial
  Instruments with Characteristics of Both
  Liabilities and Equity

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Debt vs Equity

• What do the following have in common?
• Mandatorily redeemable preferred stock
• TOPRS (trust originated preferred stock)
• Forward contracts on firms stock
• They are securities that have some
  characteristics of debt and some characteristics
  of equity.
• Some firms used to put them between liabilities
  and equity on the balance sheet (mezzanine),
  others used to put them in equity.

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Redeemable preferred stock

• Preferred stock allows for either mandatory
  redemption or redemption at the option of the
  holder.
• In other words, the firm promises to pay back the
  preferred stock at a stated price in the future.
• Is this debt or equity?

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Liability vs Equity (CON6)

• Equity or net assets is the residual interest in
  the assets of an entity that remains after
  deducting the liabilities.
• Liabilities are probable future sacrifices of
  economic benefits arising from present
  obligations of a particular entity to transfer
  assets or provide services to other entities in
  the future as a result of past transactions or
  events.

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Redeemable Preferred Stock

• Characteristics of both
• Fixed cumulative dividend payments are similar to
  interest payments.
• Fixed redemption date and price are similar to
  principal payments for debt.
• The SEC ruled that redeemable preferred stock is
  not equity, but did not state that is debt.
• So, companies put the securities between
  liabilities and equity on the balance sheet
  mezzanine.

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TOPRs (Trust Originated Preferred Stock)

• Company issues debt to a wholly owned trust.
• The trust issues preferred stock to investors and
  uses the proceeds of the issuance of the
  securities to purchase the debt from the company
  having a stated maturity.
• When the company makes its payments of interest
  to the trust, the trust distributes the cash to
  the holders of the preferred stock.
• The preferred securities must be redeemed upon
  maturity of the debt.
• The company can record interest on debt (which is
  tax deductible) instead of dividends on stock
  (which is not).

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How TOPRs work
divs
interest
Firm
Trust
Investors
loan
Buy stk.
bonds
Pfd. Stk.
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TOPRs Debt or Equity?

• Because the preferred stock in the trust is
  mandatorily redeemable, it cannot be equity
  (according to the SEC).
• But not required to call it debt.
• So firms put it in mezzanine.

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General Motors

• Trust Originated Preferred Shares

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Forward contracts on firm stock

• Firm sells a forward contract on its own stock.
• The firm receives cash and promises to buy its
  own stock at a specified date and specified
  price.
• Because it is a transaction with a current
  stockholder, it was required to be classified as
  equity (EITF 00-19)

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SFAS 150 (issued in 2003)

• Many investors were concerned (and confused)
  about the classification in the balance sheet of
  certain financial instruments that had
  characteristics of both liabilities and equity.
• Some firms classified these as equity and some as
  mezzanine.

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SFAS 150

• Requires liability classification of
• Mandatorily redeemable shares
• Any obligations to repurchase the firms own
  shares
• Unconditional obligations in which the issuer
  must or may settle by issuing a variable number
  of its equity shares if
• Fixed monetary amount known
• Varies in something other than the FV of the
  equity shares (e.g.. Index to SP 500)
• Varies inversely with FV of issuers equity shares

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SFAS 150

• What do the following have in common?
• Mandatorily redeemable preferred stock
• TOPRS (trust originated preferred stock)
• Forward contracts on firms stock
• They are all liabilities according to SFAS 150.

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Effect on Ratios

• Firearms Training Systems, Inc.
• Mandatorily Redeemable Preferred Stock

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But wait

• SFAS 150 says that an obligation that is settled
  by issuing a variable number of equity shares is
  a liability.
• That doesnt meet the definition of a liability
  under CON6
• Liabilities are probable future sacrifices of
  economic benefits arising from present
  obligations of a particular entity to transfer
  assets or provide services to other entities in
  the future as a result of past transactions or
  events.
• SFAS 150 states that FASB will amend CON6 to
  include equity issuances in the definition of a
  liability.

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What is the effect of SFAS 150?

• Many of these securities have gone away
• On April 2, 2001, GM redeemed the series G
  Trusts sole assets causing the series G trust to
  redeem the approximate 5 million outstanding
  series G 9.87 trust originated preferred shares
  (TOPRs).
• GMs 2001 10-K

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But the FASB isnt finished..

• The FASB, in a joint project with the IASB, is
  working on a comprehensive standard of accounting
  for instruments with characteristics of
  liabilities and equity.
• Develop a conceptual framework for the
  accounting.
• In the meantime, financial institutions are
  developing contracts that do not meet the
  criteria in SFAS 150 so that they are not
  considered liabilities structuring transactions
  around the new rules.

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Debt versus Equity?

• Convertible Bonds

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Convertible Bonds

• Convertible bonds are recorded like regular bonds
  the proceeds of the bonds are reported in Bonds
  Payable.
• On January 15, 2007 Malley Inc issued 1,000
  bonds at par value. The bonds were convertible
  into 200 shares of stock. The par value of the
  stock is 1 per share and the market value is 7
  per share.

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When issue the bonds.

• Cash 1000
• Bonds Payable 1000
• Notice that the bonds are recorded as if the
  entire value derives from the bond and no value
  derives from the convertibility feature.

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Convertible Bonds VerticalNet

• In 1999, to raise capital, VerticalNet offered
  for sale 100 million face value of convertible
  bonds. They had a stated (annual) rate of 5.25
  and were due in 5 years. The bonds (1,000
  denominations) were convertible into 50 shares of
  common stock.
• The bonds (like most convertible debt) were
  callable by the issuer at a fixed price prior to
  maturity, but if called, bondholders have the
  right to exercise their conversion option first
  if they want.

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VerticalNet Convertible Bonds

• 100 million face value bonds with a stated rate
  of 5.25 and due in 5 years, each 1,000 bond is
  convertible into 50 shares of common stock.
• At the time of issuance, the market rate for
  similar debt was 8 per year and VerticalNets
  stock was trading at approximately 16 per share.
  
• Note that the conversion price was fixed at 20
  per share (1,000 bond / 50 shares 20 per
  share).
• What proceeds should VerticalNet receive for the
  bonds?

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VerticalNet Convertible Bonds

• What should the bond proceeds be?
• PV(8,5) 100 PVA(8,5)5.25 89.02
• VerticalNet actually received full face value
  for the bonds. How do you interpret this?
• The convertible feature of the bond was very
  valuable (11 million)!
• Should VerticalNet have recorded the bonds at
  face value or at the present value of the
  promised cash flows at the prevailing market
  rate?

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The FASB..

• APB 14 says that the bonds are to be recorded at
  the amount of proceeds. So, all the value is
  attributable to the bonds.
• However, an argument could be made for separately
  reporting the two (or three) separate financial
  instruments represented by the convertible bonds.
  

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VerticalNet

• Suppose the bonds were recorded at par and the
  effective interest rate of 5.25 were used to
  record interest expense. (Note that the US
  governments borrowing rate for debt of similar
  duration in late 1999 was 5.9.)
• How well does the interest expense represent the
  cost of borrowing to VerticalNet?

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VerticalNet

• 5.25 recorded rate
• Carrying value x effective rate 100 x 5.25
  5.25
• 8 market rate
• Carrying value x effective rate 89 x 8
  7.12
• Interest expense is understated relative to the
  cost of the bond itself.

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Yahoo!

• In April 2003, Yahoo! Inc. sold 750 million of
  zero coupon convertible notes due in 2008 and
  received full face value for them. What will
  Yahoos interest expense be in each year?
• Interest expense would be zero.
• Recall that interest expense typically equals the
  cash payment for interest plus or minus the
  amortization of the discount or the premium.
  Normally zero coupon bonds have a very large
  discount to be amortized, but in this
  circumstance, there would be no cash payment nor
  amortization and, therefore, no interest expense
  recorded. This clearly will lead to
  misrepresented financial performance for Yahoo.

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Yahoo!

• How well does Yahoos recorded 750 million of
  debt represent the effects of the financing on
  Yahoos financial position?
• The balance sheet will report 750 million in
  debt when, in fact, this is really 750 in
  options on common stock which would ordinarily be
  reported in equity. Calling it debt is
  misleading.

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Convertible Debt

• FASB has the issue of convertible debt included
  in Phase II of the Debt/Equity project.
• IASB have separated convertible securities into
  their components since 1996.