LongTerm Debt and Other Financing Issues

1
Long-Term Debt and Other Financing Issues

• Chapter 22

2
Loan Payments and Interest

• Periodic loan payments consist of two components
• Interest expense
• A portion of the principal balance

3
Calculating Loan Payments
Periodic Payment
Amount Borrowed ?
Present Value of Annuity Factor Based on the
Interest Rate and the Life of the Loan
4
Calculating Interest Expense
Interest Expense
Book Value of Loan at the Beginning of the Period
Periodic Interest Rate X
5
Calculating Repayment of Principal
Repayment of Principal
Cash payment -
Interest expense
6
Bond Characteristics

• Face Value
• Maturity date
• Contract rate
• Bond certificate

7
Reasons for Issuing Bonds
The main reason for issuing bonds is that the
earnings available to the common stockholders can
be increased through leverage. Leverage is the
use of borrowing to increase the return
to common stockholders. It is also
call trading on equity.
8
Use of Leverage Through Bond Financing Exhibit
22-2
Before Expansion
Bond Financing
Stock Financing
Earnings before interest and income
taxes 100,000 150,000 150,000 Interest
expense ---- (30,000)
----__ Income before income taxes 100,000 120,00
0 150,000 Income tax expense (40,000)
(48,000) (60,000) Net Income 60,000
72,000 90,000 Number of shares 10,000
10,000 16,000 Earnings per share 6.00
7.20 5.63
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Recording Bonds Issued at Face Value
Cash
Bonds Payable
200,000
200,000
10
Interest Expense
Face Value of Bonds X (Annual Contract Rate ?
Number of Interest Payments per Year)
Example
200,000 X (10 ? 2) 10,000
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Recording Interest Expense
Cash
Interest Expense
10,000
10,000
12
Accrual of Interest
Semiannual Interest X Fraction of Period since
Interest Last Paid
Example
300,000 X (12 ? 2) X 4/6 12,000
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Recording Interest Expense
Interest Payable
Interest Expense
12,000
12,000
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Factors Affecting Bond Interest Rates

• The risk-free rate
• The expected inflation rate
• The risk premium

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Bonds Issued at Less Than or More Than Face Value

• Premium - bonds sold when market rate of interest
  is lower than the contract rate
• Discount - bonds sold when market rate of
  interest is higher than the contract rate
• Yield - the market rate at which the bonds are
  issued

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Bonds Issued at Less Than or More Than Face Value
The issuance of bonds sold at a discount or
premium is usually quoted as a percentage of the
face value.
Face Value X Quoted Percentage Selling
Price 200,000 X 97 194,000
200,000 X 102 204,000
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Bond Interest Expense
Interest Expense for Period Book Value at
Beginning of Period X Yield
18
Relationship Between Bond Selling Prices and
Interest Expense Exhibit 22-3
Annual Interest Expense Compared to Annual
Interest Payment
Yield Compared to Contract Rate
Bonds Sell at
Yield gt Contract Rate Discount Interest
Expense gt Interest Paid Yield Contract Rate
Face Value Interest Expense Interest
Paid Yield lt Contract Rate Premium Interest
Expense lt Interest Paid
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Zero-Coupon Bonds

• Bonds pay no interest each period
• Amount borrowed is less than face value
• Face value is paid on the maturity date
• Selling price is the present value of the face
  value using the annual yield
• Effective interest method is used for computing
  yearly interest expense

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Effective Interest Method
Selling Price of Bond Issue Face Value X
Present Value Factor
Example
1,000,000 X 0.3855 (PV of 1 factor for 10
periods at 10) 385,500
21
Interest Expense for Zero-Coupon Bonds
Interest Expense Book value at beginning of
period X Annual yield
Example
385,500 X 10 38,550
22
Recording Interest Expense
Bonds Payable
Interest Expense
Bal. 385,500
38,550
38,550
Bal. 424,050
23
Recording Retirement of Bonds
Bonds Payable
Cash
Bal. 198,000
198,000
205,000
Bal. 0
Extraordinary Loss
7,000
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Evaluation of Long-Term Debt and Interest Expense

• Financial flexibility
• Risk
• Long-term liquidity

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Leases

• Lease - an agreement giving the right to use
  property, plant, or equipment without
  transferring legal ownership
• Lessee - the company that acquires the right to
  use the item
• Lessor - the company that gives up the use of the
  item

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Types of Leases

• Capital Lease - transfers the risks and benefits
  of ownership from the lessor to the lessee
• Operating Lease - does not transfer the risks and
  benefits of ownership

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Capital Lease
The lessee records an operating asset and a
long-term liability at the present value of the
lease payments.
Present value of lease payments Periodic
lease payment X Present value of annuity
factor
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Recording a Capital Lease
Leased Property
Capital Lease Obligation
15,163
15,163
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Recording Depreciation on Leased Asset
Leased Property
Depreciation Expense
3,033
Bal. 15,163
3,033
Bal. 12,130
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Interest Expense for Capital Leases
Interest Expense Book value of lease
obligation X Interest rate
Example
15,163 X 10 1,516
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Reduction of Lease Obligation
Reduction of lease obligation Cash payment to
lessor - Interest expense
Example
4,000 - 1,516 2,484
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Recording Lease Payment
Capital Lease Obligation
Cash
Bal. 15,163
4,000
2,484
Bal. 12,679
Interest Expense
1,516
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Mortgage Payable
A mortgage payable is a long-term liability for
which the lender has a specific claim against an
asset of the borrower. Accounting for a mortgage
payable is similar to accounting for a lease
obligation.
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Deferred Income Taxes

• A temporary difference occurs when a corporation
  uses different depreciation methods between the
  accounting records and tax records
• Deferred Tax Liability - balance sheet account
  showing future additional income taxes
• Deferred Tax Asset - balance sheet account
  showing the amount by which future income taxes
  will be reduced

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Retirement Benefits

• Pension plan - an agreement by a company to
  provide income to its employees after they retire
• Defined-contribution plan - specifies the amount
  that the company must contribute to the plan
  while the employees are working
• Defined-benefit plan - specifies the amount that
  the company must pay to its employees during
  retirement

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Conclusion
A bond is a type of note in which a company
agrees to pay the holder the face value at the
maturity date and to pay interest periodically at
a specified rate on the face value. A lease is an
agreement giving a company the right to use
property, plant, or equipment without
transferring legal ownership of the item.
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Problem 22-23
Present Value Periodic Amount of X Present
Value of of annuity annuity
Annuity Factor
10,000 Periodic Amount of Annuity X
3.4651 Periodic Amount of Annuity 2,885.92
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Problem 22-23
Beginning Ending Balance
Interest Principal Balance 1999 10,000.00
600.00 2,285.92 7,714.08 2000 7,714.08
462.84 2,423.08 5,291.00 2001 5,291.00
317.46 2,568.46 2,722.54 2002
2,722.54 163.38 2,722.54 -0-