Chapter 8 Sources of Capital: Debt McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved.

8-2 Liability  Definition Obligation to an outside party. Obligation to an outside party. Arises from a transaction or an event that has already happened. Arises from a transaction or an event that has already happened.  Estimated warranty is an example of a liability that is not legally enforceable.

8-3 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.

8-4 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.

8-5 Contingency  Equal uncertainty as to possible gain or loss that will ultimately be resolved by some future event.  Gain contingencies usually not reported (conservatism).

8-6 Loss Contingency  Potential future payment from existing conditions.  Uncertainty about amount.  Outcome will be resolved by future events.

8-7 Levels of Likelihood/GAAP  Probable Reasonably estimated/Accrue. Reasonably estimated/Accrue. Not reasonably estimated/Disclose Not reasonably estimated/Disclose  Reasonably possible/Disclose  Remote/No accrual; no disclosure.

8-8 Are These Contingent Liabilities? How Handled on FS?  We expect to be sued due to damage caused by our product. Outcome unknown.  Pending lawsuit. Probable loss from $100K to $2KK. (What if 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. Warranty costs are 3% of sales. Bad debts are 2% of sales. Bad debts are 2% of sales.

8-9 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).

8-10 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 Specified sum of money at a stated date and Interest at a stated rate until maturity. Interest at a stated rate until maturity. Price quoted as % of face, e.g., 98 or 102. Price quoted as % of face, e.g., 98 or 102.

8-11Bonds  Interest rate usually constant through life, could be variable.  Bond indenture  Contains covenants which are requirements such as maintaining certain minimum financial ratios.  If covenants are not met, then the 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.

8-12 Bond Redemption  Payment of principal at maturity of bonds. Thus, cancellation (under some circumstances earlier than maturity). Thus, cancellation (under some circumstances earlier than maturity).  Sinking fund bonds.  Require the company to set 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.

8-13 Other Bond Features  Serial. Redeemed in installments. Redemption date specified on bond itself. 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.  Callable.

8-14Terms  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.

8-15 Accounting for Bonds: Issuance at Par - No Issuance Costs  Cash 100  Bonds payable100

8-16 Accounting for Bonds: Issuance at Par - With Issuance Costs Cash 100 Cash 100 Deferred charges - bond issuance costs 5 bond issuance costs 5 Bonds payable105

8-17 Discount and Premium  Higher risk, higher return expected by investors. Higher interest rate, i.e., given a stated interest rate, lower selling price. Higher interest rate, i.e., given a 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.

8-18 Issuing Bonds w/ Premium or Discount Cash 94 Bond Discount 6 Bonds payable100 Cash 103 Bonds payable100 Bond premium 3

8-19 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? Interest payments of $25 at the end of each of 20 six month periods. (An ordinary annuity.) 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. A lump-sum payment of $1,000 at the end of 10 years.

8-20 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): PV of interest payments (ordinary annuity): # of bonds* Interest paid per period*PV factor (n,i)# of bonds* Interest paid per period*PV factor (n,i) 4000 bonds*$25* =$1,487, bonds*$25* =$1,487,748 PV of payment at maturity(lump-sum payment) PV of payment at maturity(lump-sum payment) # of bonds *face*PV factor (n,i)# of bonds *face*PV factor (n,i) 4000*$1,000* =$2,214, *$1,000* =$2,214,704 Total = $1,487,748 + $2,214,704 = $3,702,452 Total = $1,487,748 + $2,214,704 = $3,702,452

8-21 Entry to Record Issuance Cash 3,702,452 Bond Discount 297,548 Bond Discount 297,548 Bonds Payable 4,000,000 Bonds Payable 4,000,000

8-22 Book Value  Net book value = principal plus unamortized premium or less unamortized discount.  Net carrying amount = book value less unamortized deferred charges (issuance costs).

8-23 Bond Interest Expense  2 components: Cash interest payments (usually semi- annual). Cash interest payments (usually semi- annual). Amortization of bond premium or discount. 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.

8-24 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).

8-25 Effective Interest Rate Method Bond Disc. Amortization Table  Beginning book value. Bonds payable – unamort. Disc. (or + Prem.). Bonds payable – unamort. Disc. (or + Prem.).  Interest expense. Beginning book value * effective interest rate. Beginning book value * effective interest rate.  Interest paid. Face amount * stated interest rate. Face amount * stated interest rate.  Discount amortization. Interest expense - interest paid. Interest expense - interest paid.  Ending book value. B. payable - new unamort. Disc. (or + Prem.). B. payable - new unamort. Disc. (or + Prem.).

8-26 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

8-27 Leased Assets  Operating leases:  Rent or leases in which payments are expensed.  Capital or financing 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 the creation of a liability.

8-28 Deferred Income Taxes  Arises when book income  taxable income.  Matching concept (or accrual income concept): Income tax expense is the amount that will eventually be paid on the income recorded in the books (i.e., on the IS) in the period. Income tax expense is the amount that will eventually be paid on the income recorded in the books (i.e., on the IS) in the period. =Currently payable + deferred.=Currently payable + deferred. Deferred income tax liability (or asset): Deferred income tax liability (or asset): Difference between income taxes on book earnings to date and income taxes on tax returns to date.Difference between income taxes on book earnings to date and income taxes on tax returns to date.

8-29 Analysis of Capital Structure  Invested capital = permanent capital = debt capital + equity capital.  Leverage = measure of soundness of company’s financial position.  Debt equity ratio = (total liabilities or non-current liabilities or interest bearing liabilities)  Shareholders’ equity.  Debt capitalization ratio = Debt / (Debt + shareholders’ equity).  Times interest earned = interest coverage ratio = Pre-tax income before interest expense / interest expense.

8-30 Bond Ratings  Indicates probability of going into default (not paying required interest or principal).  Uses ratios such as debt-equity and other information.  Bond rating agencies include: Standard & Poor’s. Standard & Poor’s. Moody’s. Moody’s.

8-31 Discussion Questions  What has more risk: debt or equity capital? From company point of view? From company point of view? From investor point of view? From investor point of view?  Why do we use the term leverage for the debt-to-equity ratio?