COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1 Chapter 10 Long-Term Debt Financing Albrecht, Stice, Stice, Swain

2 Present Values The value today of $1 to be received or paid in the future, given a specified interest rate. $90.91 is the present value of $100 received in one year. $90.91$100One Year Period at 10% rate Present Value

3 Future Values The value in the future of $1 to be received or paid today, given a specified interest rate. $100 is the future value in one year of $90.91 paid or invested today. $90.91$100One Year Period at 10% rate Future Value

4 Computing Present Values Using present value tables (Table I): Choose the time period and interest rate used. Multiply the factor by the amount to be received in the future. Period7%8%9%10%12% $100 X = $90.91

5 Computing Future Values Using future value tables (Table III): Choose the time period and interest rate used. Multiply the factor by the amount invested today. Period7%8%9%10%12% $90.91 X 1.10 = $100

6 Annuities A series of equal amounts to be received or paid at the end of equal time periods. Present values or future values can be computed for annuities. –Use number of periods and rate to find appropriate factor. –Multiply the factor by the annuity (payment) amount. Present value factor of annuity (Table II) X Payment = Present value

7 Notes Payable Long-term debt that is paid back at the end of the loan term. Interest is usually paid throughout the loan period. To record a loan from the bank (2 year 10% loan): Cash ,000 Notes Payable ,000 To record the interest for year 1: Interest Expense ,000 Cash ,000 To record the repayment of the loan and year 2 interest: Notes Payable ,000 Interest Expense ,000 Cash ,000

8 Mortgages A written promise to pay a stated amount of money. Secured by the pledging of certain assets. Liability recorded on the balance sheet is the amount borrowed (which is also the present value of the future payments). A company takes out a 30-year, $100,000 mortgage with monthly payments. The interest rate on the mortgage is 8%. The monthly payments are $733.76: Cash ,000 Mortgage Payable ,000

9 Mortgage Amortization Part of each mortgage payment pays off interest due and part of the payment reduces the principal amount due. A schedule can be prepared showing the portions of each payment that are principal and interest. InterestPrincipalBalance Payment(Balance X Interest Rate)(Payment – Interest) 100, , , , , , ,590.67

10 Mortgage Amortization InterestPrincipalBalance Payment(Balance X Interest Rate)(Payment – Interest) 100, , , , , , , Recording the payment for month 5: Interest Expense Mortgage Payable Cash

11 Leases Capital leases –Asset and obligation reported on the balance sheet are the present value of the future lease payments. –Yearly interest expense based off of remaining lease liability balance (like mortgage amortization). Leased equipment for $10,000 a year, discounted at 14%: Leased Equipment ,161 Lease Liability ,161 Record interest expense and first $10,000 payment: Interest Expense ,303 Lease Liability ,697 Cash ,000 (Interest expense = 52,161 X 0.14 = 7,303)

12 Bonds Bond –A contract between the borrowing company (issuer) and the lender (investor) in which the borrower promises to pay a specified amount of interest at the end of each period for which the bond is outstanding. The principal is then paid back at maturity. Debentures –Bonds that have no underlying assets pledged as collateral. Secured bonds –Bonds that have assets pledged as protection for lenders. Registered bonds –The issuing company keeps a record of the names of bondholders. Those registered bondholders are paid interest. Coupon bonds –The issuing company has no record of the bondholders. Current bondholders redeem coupons for interest payments.

13 More Bond Terms Term bonds –Bonds that mature in one single sum on a future specified date. Serial bonds –Bonds that mature in a series of installments. Callable bonds –Bonds that can be redeemed any time at a specified price. Convertible bonds –Bonds that can be converted to other securities (i.e. preferred stock or common stock) at the option of the bond holder. Zero coupon bonds –Bonds issued with no promise of payment. Junk bonds –High-risk bonds issued by a company with a lot of outstanding debt or in a weak financial position.

14 Characteristics of Bonds Face value or maturity value –The principal amount that will be repaid at maturity. –Usually issued in $1,000 increments. Stated rate of interest –The amount of interest the company promises to pay. Market rate of interest –What the market is paying for bonds of a similar nature.

15 Bond Issuance The bond’s face value and future interest payments (face value X stated rate of interest) are discounted by the market rate of interest to arrive at the issuance price. If the stated rate of interest is LESS than the market rate of interest, the bond is issued at a DISCOUNT. If the stated rate of interest is MORE than the market rate of interest, the bond is issued at a PREMIUM.

16 Bonds Issued at Face Value Sayer Co. issues $100,000, 5-year bonds with a stated rate of interest of 10%. The effective rate (market rate of interest) is also 10%. 1.Semiannual interest payment ,000 Present value of an annuity of 10 payments of $1 at 5% (Table II) X , Maturity value of bond ,000 Present value of $1 received 10 periods in the future discounted at 5% (Table I)....X ,391 3.Issuance price of bond ,000

17 Bonds Issued at a Discount Sayer Co. issues $100,000, 5-year bonds with a stated rate of interest of 10%. The effective rate is 12%. 1.Semiannual interest payment ,000 Present value of an annuity of 10 payments of $1 at 6% (Table II) X , Maturity value of bond ,000 Present value of $1 received 10 periods in the future discounted at 6% (Table I)....X ,840 3.Issuance price of bond ,640

18 Bonds Issued at a Premium Sayer Co. issues $100,000, 5-year bonds with a stated rate of interest of 10%. The effective rate is 8%. 1.Semiannual interest payment ,000 Present value of an annuity of 10 payments of $1 at 4% (Table II) X , Maturity value of bond ,000 Present value of $1 received 10 periods in the future discounted at 4% (Table I)....X ,560 3.Issuance price of bond ,114

19 Accounting for Bonds Bonds issued at face value: Issuance of bond: Cash ,000 Bonds Payable ,000 Make semiannual interest payment: Interest Expense ,000 Cash ,000 Retirement of bond: Bonds Payable ,000 Cash ,000

20 Early Retirement of Bonds Bonds are sometimes retired before maturity. –The difference between the face value and the price paid to retire the bonds is recognized as a gain or loss. Retirement of Sayer Co. bond at 105: Bonds Payable ,000 Loss on Bond Retirement ,000 Cash ,000

21 Debt-Related Financial Ratios Debt ratio –Represents the amount of assets financed through debt. Debt-to-equity ratio –The number of dollars of debt for every dollar invested by stockholders. Total Liabilities Total Assets Total Liabilities Total Stockholders’ Equity

22 Times Interest Earned Times Interest Earned Ratio –The ratio of the income that is available for interest payments. –Measures how much a cushion has in making its interest payments. –The higher the better. Earnings Before Interest and Taxes Interest Expense

23 Bonds Issued at a Discount or Premium Using the Sayer Co. examples, Bonds issued at a discount: Bonds issued at a premium: Issuance of bonds: Cash ,640 Discount on Bonds ,360 Bonds Payable ,000 Issuance of bonds: Cash ,114 Premium on Bonds ,114 Bonds Payable ,000

24 Straight-Line Amortization The discount or premium needs to be amortized over the life of the bond so the value of the bond is equal to the face value at maturity. Straight-line amortization –Divide the discount or premium by the number of interest periods and recognize that amount as extra interest expense (for discounts) or less interest expense (for premiums).

25 Straight-Line Amortization Bonds issued at a discount: The same entry would be made for each interest payment. A similar entry would be made to amortize a premium, but the premium would be debited and interest expense would be reduced. Discount ,360 Number of semiannual periods ÷ Payment of semiannual interest: Interest Expense ,736 Discount on Bonds Cash ,000

26 Effective Interest Amortization Amortizes a varying amount of discount or premium each period. This amount is the difference between the interest actually incurred and the cash actually paid (like the amortization schedule for the mortgage). Interest actually incurred is the bond carrying value multiplied by the effective interest rate.

27 Effective Interest Amortization For Bond issued at premium: Interest IncurredAmortization of PremiumBond Carrying (Bond Carrying Value X(Interest Incurred –Value PaymentEffective Interest Rate)Payment) 108,114 15,0004, ,439 25,0004, ,737 35,0004, ,006 45,0004, ,246 55,0004, ,456 4 th Payment of semiannual interest: Interest Expense ,240 Premium on Bonds Cash ,000

28 Retirement of Bonds with a Discount or a Premium Retirement at maturity is the same as at face value because the discount or premium is amortized to zero at maturity. Sayer Co. desires to retire its 5-year bonds issued at a premium after 2 years (4 payments). The bonds are retired at 105: Retirement of Sayer Co. bond at 105: Bonds Payable ,000 Premium on Bonds ,246 Gain on Bond Retirement Cash ,000