ANALYSIS OF FINANCING LIABILITIES

FOCUS Understand the FS effects of issuing a bond at par, at a discount, or at a premium. Calculate the book value of the bond and interest expense at any point of time using the effective interest rate method. Calculate the gain or loss from retiring a bond before its maturity date

FINANCING LIABILITIES A bond is a contractual promise between a borrower and a lender that obligates the bond issuer to make payments to the bondholder over the term of the bond. Two types: periodic interest payments, repayment of principal at maturity.

The face value: maturity value/ par value: the amount of principal that will be paid to the bondholder at maturity  used to calculate the coupon payments. The coupon rate: the interest rate stated in the bond  used to calculate the coupon payments. The coupon payments: the periodic interest payments to the bondholders.

The effective rate of interest: interest rate that equates the present value of the future CF of the bond and the issue price. The balance sheet liability: equal to the present value of its remaining CF, discounted at the market rate of interest at issuance. The interest expense: is calculated by multiplying the book value of the bond liability at the beginning of the period by the market rate of interest of the bond when it was issued.

The market rate = coupon rate  par bond (priced at face value) Market rate > coupon rate  discount bond (priced below par) Market rate < coupon rate  premium bond (priced above par)

EXAMPLE: BOOK VALUES AND CF On Dec 31, 20X2, a company issued a 3 year, 10% annual coupon bond with a face value of $100,000. Calculate the book value of the bond at year – end 20X2, 20X3, 20X4 and the interest expense for 20X3, 20X4 and 20X5, assuming the bond was issue at a market rate of interest of 10%, 9% and 11%

FS EFFECTS OF ISSUING A BOND Cash flow impact of issuing a bond Cash flow from financing Cash flow from operations Issuance of debtIncreased by cash received No effect Periodic interest payments No effectDecreased by interest paid Payment at maturity Decreased by face value No effect

Income statement impact of issuing a bond Interest expense = market rate at issue x balance sheet value of liability at beginning of period Issued at parIssued at premiumIssued at a discount Market rate = coupon rate Market rate < coupon rate Market rate > coupon rate Interest expense = coupon rate x face value = cash paid Interest expense = cash paid – amortization of premium Interest expense = cash paid + amortization of discount Interest expense is constant Interest expense decreases over time Interest expense increases over time

Balance sheet impact of issuing a bond Issued at parIssued at a premiumIssued at a discount Carried at face value Carried at face value plus premium Carried at face value less discount The liability decreases as the premium is amortized to interest expense The liability increases as the discount is amortized to interest expense

THE ROLE OF DEBT COVENANTS IN PROTECTING CREDITORS Debt covenant: restrictions imposed by the lender on the borrower to protect the lender’s position. Can reduce default risk and reduce borrowing costs. The restrictions can be in the form of affirmative covenants or negative covenants.

AFFIRMATIVE COVENANTS Make timely payments of principal and interest Maintain certain ratios in accordance with specified levels. Maintain collateral

NEGATIVE COVENANTS Increasing dividends or repurchasing shares. Issuing more debt. Engaging in mergers and acquisitions.

DISCLOSURES RELATING TO DEBT Balance sheet Footnote disclosure The nature of the liabilities Maturity dates Stated and effective interest rates Call provisions and conversion privileges Restrictions imposed by creditors Assets pledged as security The amount of debt maturing in each of the next five years

MOTIVATIONS FOR LEASING INSTEAD OF PURCHASING THEM Finance lease: a purchase of an asset that is financed with debt. The lease will add equal amounts to both assets and liabilities on the balance sheet,. the lease will recognize depreciation expense on the asset and interest expense on the liability.

Operating lease: Is essentially a rental arrangement Not asset or liability is reported by the lessee The periodic lease payments are simply recognized as rental expense in the income statement.

CERTAIN BENEFIT FROM LEASING Less costly financing Reduced risk of obsolescence Less restrictive provisions Off balance sheet financing Tax reporting advantages

DISTINGUISH FINANCE LEASE AND OPERATING LEASE LESSEE’S PERSPECTIVE: require a lease to be treated as a finance lease, include: -Title to the leased asset is transferred to the lessee at the end of the lease. -The lease term covers a major portion of the asset’s economic life (75% or more) -The present value of the lease payment is 90% or more of the fair value of the leased asset

LESSOR’S PERSPECTIVE: -Finance lease: all rights and risks of ownership are transferred to the lease -Operating lease: the lessor recognizes rental income and continues to report and depreciate the leased asset on its balance sheet.

DETERMINE THE INITIAL RECOGINITION AND MEASURMENT REPORTING BY THE LEASE: -Operating lease:  the balance sheet is unaffected.  No asset or liability is reported by the lessee.  During the term of the lease, rent expense equal to the lease payment is recognized in the lessee’s income statement.  In the CFS, the lease payment is reported as an outflow from operating activities

Finance lease:  The lower of the present value of future minimum lease payments or the fair value of the leased asset is recognized as both an asset and liability on the lessee’s balance sheet.  The asset is depreciated in the income statement and interest expense is recognized.  Interest expense is equal to the lease liability at the beginning of the period multiplied by the lease interest rate

FS AND RATIO EFFECTS OF OPERATING AND FINANCE LEASES Balance sheet: -A finance lease results in a reported asset and a liability. -Turnover ratios that use total or fixed assets in their denominators will be lower when a lease is treated as a finance lease. -ROA will also be lower for finance leases. -Leverages ratio, debt to assets ratio, debt to equity will be higher with finance leases then operating leases.

Income statement:  EBIT will be higher for companies that use finance leases relative to companies that use operating leases.  Operating lease: entire lease payment is an operating expense  Finance lease: only depreciation of the leased asset is treated as an operating expense.

Cash flow statement: -Total cash flow is unaffected by the accounting treatment of a lease. -If the lease is treated as an operating lease  the total cash payment reduces cash flow from operations. -If the lease is treated as a finance lease  the portion of the lease payment that is considered interest expense reduces CF from operations.

FINANCE LEASEOPERATING LEASE AssetsHigherLower Liabilities (current and long term) HigherLower Net income (in the early years) LowerHigher Net income (later years) HigherLower Total net incomeSame EBIT (operating income) HigherLower CF from operationsHigherLower CF from financingLowerHigher Total cash flowSame

FINANCE LEASEOPERATING LEASE Current ratioLowerHigher Working capitalLowerHigher Asset turnoverLowerHigher Return on assetsLowerHigher Return on equityLowerHigher Debt/ AssetsHigherLower Debt/ EquityHigherLower