Overview: Financing Decisions - Debt

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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING
REPORTS
Baginski Hassell
Electronic presentation adaptation by Dr.
Barbara L. Hassell Dr. Harold O. Wilson
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Chapter 3
FINANCING DECISIONS DEBT
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Financing Decisions - Debt

• Topics
• Characteristics of debt securities
• Cash interest versus effective interest
• Effective interest overview
• Computation of effective interest
• Accounting for long-term bonds payable

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• Application of effective interest method to
  bonds payable
• Example illustrating effective interest method
• Notes payable
• Debt-like characteristics of preferred stock
• Hybrid securities
• Convertible debt

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Characteristics of Debt Securities

• Security
• Claims against specific asset (secured)
• General claims against all assets (unsecured)
• Maturity
• Have a definite maturity date
• May be callable earlier at the borrowers
  discretion

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• Convertibility
• Normally, debt is not convertible into other
  securities.
• Debt securities, particularly bonds, may be
  convertible into common stock at holders
  discretion.
• Bonds may be issued with detachable warrants,
  which allow the holder to purchase common
  stock at predetermined prices.

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• Interest payment characteristics
• In general, debt has a fixed maturity value
  (principal) and a stated interest rate.
• Maturity value (principal) also is referenced as
  face value or par value.

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Cash Interest

• Cash Interest Paid by Debtor
• Multiply maturity value times the stated interest
  rate (as printed on the instrument)
• Example On January 1, 2001, the Liu Co. issued
  10,000,000 of 10 year, 8 bonds due January 1,
  2011, with interest to be paid annually on
  January 1. (Liu will disburse cash interest of
  800,000 each year, on January 1, starting on
  January 1, 2002.)

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Effective Interest Overview

• Effective Interest
• The market rate of interest for debt (on the
  date of transaction), being a function of
  economy-wide conditions and borrower-specific
  risk factors.
• Components
• Underlying real rate of return
• Inflation premium
• Risk premium

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Effective Interest Computation

• Mathematics of Finance (in general) is based on
  five variables
• n Number of interest payment periods
• P Principal (or present value) - the amount
  being borrowed
• MV Maturity (or future) value of the debt
• R Rent (generic term) payments on rented
  capital, i.e., the interest payment per period
  (n) and ...

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• i Interest (or market) rate per period (also
  know as the effective rate per period)

Note Investors compare investment opportunities
by comparing respective rates of return
available, by calculating effective rates per
year. For example, a stated rate of 8,
compounded semiannually equates to a effective
rate per year of 8.16.
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• Of course, payments (R), representative of the
  cash interest payments over n periods, may be
  arranged as either
• Ordinary annuity payments (payments at the end
  of each period), or
• Annuity due payments (payments at the
  beginning of each period).

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Typically, if three of the variable factors are
given (known), financial calculators y aid in
easily deriving the other two an example
relating to bonds (where four givens are
needed), follows. The focus of such problems is
very often the effective interest rate being
earned per period or per year.
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• The Present Value of a bond investment (i.e., an
  investors bid price (also known as the market,
  sales, or issue price of a bond)
• The present value of future cash interest
  annuity PLUS the present value of the future
  maturity value, both discounted by using the
  current market rate of interest for similar
  debts.

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• EXAMPLE On January 1, 2001, the Liu Co. issued
  10,000,000 of 10 year, 8 bonds due January 1,
  2011, with interest paid annually on January 1.
  Given that the market price (sales price) of the
  bonds is 9,358,234 (rounded to nearest dollar),
  solve for the effective interest rate per year,
  i.
• Solution PVdeal 9,358,234 n 10 MV
  10,000,000 R interest payment per period
  (ordinary annuity) 10,000,000 x 8 800,000
• i ? 9!

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Accounting for Long-term Bonds Payable

• At Issuance
• Bonds payable are recorded by the debtor at the
  issue (sale) price, by reflecting any ...
• Premium situation bonds issued at greater
  amount than maturity value (risk low)
• Discount situation bonds issued at lesser
  amount than maturity value (risk high)
• Book value (or carrying value) The face value
  plus/minus any premium/discount

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• If bonds are issued between interest payment
  dates, the buyer also pays the issuer accrued
  interest from the last interest payment date to
  date of issuance. ()
• At the next interest payment date, the issuer
  pays the entire amount due for a full interest
  payment period.

() This principle applies to any acquisition of
bonds from any seller, just as it applied to the
original issuer involved. This traditional
procedure is fair to all. Why?
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• After Issuance
• After issuance, bond accounting uses the
  effective interest method, which emphasizes the
  interest expense per period.
• Premium/discount amortization per period is the
  difference between interest expense calculation
  and cash interest paid (or payable).

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Application of Effective Interest Method

• Calculated on a per period basis with ...
• n number of interest payments to be made (i.e.,
  periods during the life of the debt security)

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• Computation
• Beginning of the period carrying (book) value
• x Historical effective interest rate at time of
  issuance
• x appropriate time frame
• Interest expense
• - Interest paid (or payable)
• Premium/discount amortization for the period!

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• EXAMPLE Apply effective interest method after
  calculating the effective interest rate per
  period.
• Facts On January 1, 2001, the Faulconer Co.
  issued (for 4,550,000) the following bond
  4,000,000 of 7-year, 8 bonds, due January 1,
  2008 interest is paid semiannually (on July 1
  and January 1) each year. Faulconer incurred
  75,000 in transactions costs.

Note Any bond issue costs are recorded
separately and amortized over the life of the
bond.
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• Solution The effective interest rate 2.8 per
  semiannual period a 5.6, compounded
  semiannually stated rate.
• Documentation
• n 14 (7year bonds x 2 semiannual periods)
• R interest payment per period 160,000
  (4,000,000 x 8 x one-half year)
• PVdeal, present value purchase price
  4,550,000
• MV in the future 4,000,000 face value
• i per n ? 2.8
• 
  THEN ...

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Faulconer Co. Computation of Interest Expense,
First Semiannual Period
Beginning carrying value (1/1/01) 4,550,000
Effective interest rate per n 2.8
Interest expense (1/1/01 6/30/01) 127,400
Interest payable (1/1/01 6/30/01) 160,000
Premium amortization 32,600
Thus, ending carrying value (6/30/01) 4,550,000 - 32,600 4,517,400
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Faulconer Co. Financial Statement Information
For six months ended June 30, 2001
Statement of Cash Flows
Operating activities
(No Effect as of June 30()
Income Statement
Interest expense - bonds 127,400
() Interest will be paid on July 1.
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Balance Sheet
Current Liabilities
Interest payable 160,000
Long-term Liabilities
Bonds payable 4,000,000
Premium 517,400 4,517,400
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Partial Bond Amortization Schedule
Faulconer Co. Effective Interest Amortization Table Bond Premium Faulconer Co. Effective Interest Amortization Table Bond Premium Faulconer Co. Effective Interest Amortization Table Bond Premium Faulconer Co. Effective Interest Amortization Table Bond Premium Faulconer Co. Effective Interest Amortization Table Bond Premium
Date 4 Cash Interest 2.8 Eff. Interest Expense Premium Amort. Book Value of Debt
1/1/01 4,550,000
7/1/01 160,000 127,400 32,600 4,517,400
1/1/02 160,000 126,487 33,513 4,483,887
7/1/02 160,000 125,549 34,451 4,449,436
Beginning Book Value x 2.8 effective interest rate Beginning Book Value x 2.8 effective interest rate Beginning Book Value x 2.8 effective interest rate Beginning Book Value x 2.8 effective interest rate Beginning Book Value x 2.8 effective interest rate
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Accounting for Notes Payable

• Normally issued for cash, but may be issued for
  non-cash consideration (e.g., goods and
  services).
• Apply the effective interest method if issued
  for a premium/discount (rare).

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• Notes payable, as compared to bonds, are more
  likely to be issued at face value, but may be
  issued at a premium or discount
• If stated and market interest rates are equal,
  the note is issued at face value, and no premium
  or discount occurs.
• This happens because the borrower and lender have
  typically agreed to base the notes terms to
  reflect the market rate of interest on the date
  of the transaction.

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Debt-like Characteristics of Preferred Stock

• Preferred stock and convertible preferred stock
  are equity securities with some debt-like
  features
• Like debtholders, preferred shareholders have
  priority in liquidation over common stockholders.
  (Note Debt-holders have priority in
  liquidation over all shareholders).

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• Stated dividend preference per period is somewhat
  similar to a stated interest rate.
• If preferred stock is cumulative and current
  period dividends are not declared, then dividends
  in arrears is somewhat similar to interest
  payable.
• Note Neither debt holders nor preferred
  stockholders vote.

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Hybrid Securities

• Hybrid securities are securities that have both
  debt-like and equity-like characteristics.
• Examples
• Convertible debt incorporates an option to
  acquire common stock.
• Total FMV is attributed to the debt feature, per
  se.

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• Debt incorporating detachable warrants (Note
  Warrants may be tendered to acquire common
  stock.)
• The FMV of the debt security is allocated between
  debt features and the equity features, preferably
  based, on the relative separate FMVs of the
  debt and warrants (if practical).

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Convertible Debt

• EXAMPLE On January 1, 2001, the Lopez Co.
  issued at face value of 5,000,000 of 8-year,
  10 convertible debentures, due January 1, 2009.
  Interest is paid annually on December 31. Each
  1,000 bond is convertible into 30 shares of
  Lopezs 10 par common stock at the option of the
  holder. On January 1, 2003 (after payment of the
  December 31, 2002, interest payment), all bonds
  were converted to common stock.
• The balance sheet presentation just before and
  just after the conversion is as follows

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Lopez Co. Balance Sheet
Before conversion
Long-term liabilities
Bonds payable 5,000,000
After conversion
Stockholders Equity
Common Stock (1) 1,500,000
Additional paid-in capital (2) 3,500,000
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Documentation
(1) 5,000 bonds x 30 shares 150,000 shares, and 150,000 shares x 10 par 1,500,000
(2) 5,000,000 book value of debt - 1,500,000 par value of stock
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FAQs?
What would be the impact on the journal entry if
the FMV of the common stock in the above example,
at the time of conversion being 25 per share?
being 35 per share? How would
premiums/discounts affect it? Give it a shot!
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End of Chapter 3