Chapter 8Chapter 8

Sources of Capital:Sources of Capital:DebtDebt

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved.

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LiabilityLiability

DefinitionDefinition Obligation to an outside party.Obligation to an outside party. Arises from a transaction or an event that has Arises from a transaction or an event that has

already happened.already happened.

Estimated warranty is an example of a Estimated warranty is an example of a liability that is not legally enforceable.liability that is not legally enforceable.

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Legal Obligations That Are Not Legal Obligations That Are Not Accounting LiabilitiesAccounting Liabilities

Executory contracts = contracts in which Executory contracts = contracts in which neither party has yet performed.neither party has yet performed. Sales contract for future delivery of certain Sales contract for future delivery of certain

goods to the buyer.goods to the buyer. Contract to pay a baseball player $1 million Contract to pay a baseball player $1 million

per year for five years.per year for five years. A contract to provide legal services next year.A contract to provide legal services next year.

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Are These Liabilities?Are These Liabilities?

Receive $50,000 retainer for legal services Receive $50,000 retainer for legal services to be performed on an as-needed basis to be performed on an as-needed basis next year.next year.

Purchase contract for future delivery of Purchase contract for future delivery of certain goods from the seller. certain goods from the seller.

Seller of a house receives $10,000 as a Seller of a house receives $10,000 as a non-refundable deposit. non-refundable deposit.

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ContingencyContingency

Equal uncertainty as to possible gain or Equal uncertainty as to possible gain or loss that will ultimately be resolved by loss that will ultimately be resolved by some future event.some future event. Gain contingencies usually not reported Gain contingencies usually not reported

(conservatism).(conservatism).

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Loss ContingencyLoss Contingency

PotentialPotential future payment from future payment from existing existing conditions.conditions.

UncertaintyUncertainty about amount. about amount. Outcome will be resolved by Outcome will be resolved by future eventsfuture events..

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Levels of Likelihood/GAAPLevels of Likelihood/GAAP

ProbableProbable Reasonably estimated/Accrue.Reasonably estimated/Accrue. Not reasonably estimated/DiscloseNot reasonably estimated/Disclose

Reasonably possible/DiscloseReasonably possible/Disclose Remote/No accrual; no disclosure.Remote/No accrual; no disclosure.

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Are These Contingent Liabilities?Are These Contingent Liabilities?How Handled on FS?How Handled on FS?

We expect to be sued due to damage caused by our We expect to be sued due to damage caused by our product. Outcome unknown.product. Outcome unknown.

Pending lawsuit. Probable loss from $100K to $2KK. Pending lawsuit. Probable loss from $100K to $2KK. (What if reasonably possible?)(What if reasonably possible?)

Lawsuit pending. Remote chance of loss.Lawsuit pending. Remote chance of loss.

Sales during year were $1KK. Products warranted for Sales during year were $1KK. Products warranted for 1 year. Historically, 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.

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Sources of FundsSources of Funds

Debt capital.Debt capital. Company pays for use of capital that others Company pays for use of capital that others

furnish.furnish. Equity capital.Equity capital.

Obtained from shareholders.Obtained from shareholders. Direct contribution (paid-in capital).Direct contribution (paid-in capital). Indirect contribution (retained earnings).Indirect contribution (retained earnings).

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Debt CapitalDebt Capital

Debt instruments.Debt instruments. Term loans.Term loans.

Repayable according to a specified schedule Repayable according to a specified schedule usually with equal installments of principal and usually with equal installments of principal and interest.interest.

Bond.Bond. Certificate promising to pay its holder:Certificate promising to pay its holder:

Specified sum of money at a stated date andSpecified 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.

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BondsBonds

Interest rate usually constant through life, Interest rate usually constant through life, could be variable.could be variable.

Bond indentureBond indenture Contains covenants which are requirements such Contains covenants which are requirements such

as maintaining certain minimum financial ratios.as maintaining certain minimum financial ratios. If covenants are not met, then the loan is technically in If covenants are not met, then the loan is technically in

default; creditors can demand immediate payment or default; creditors can demand immediate payment or changes to be made by management.changes to be made by management.

Mortgage bond is secured by pledged assets.Mortgage bond is secured by pledged assets. Debenture bond is not secured by specific assets.Debenture bond is not secured by specific assets.

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Bond RedemptionBond Redemption Payment of principal at maturity of bonds.Payment of principal at maturity of bonds.

Thus, cancellation (under some circumstances Thus, cancellation (under some circumstances earlier than maturity).earlier than maturity).

Sinking fund bonds.Sinking fund bonds. Require the company to set aside Require the company to set aside

cash/investments to be used to redeem bonds at cash/investments to be used to redeem bonds at maturity or at regular intervals. maturity or at regular intervals. Sinking funds are controlled by a trustee (e.g., a bank).Sinking funds are controlled by a trustee (e.g., a bank). Shown on BS as Investments or other assets.Shown on BS as Investments or other assets.

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Other Bond FeaturesOther Bond Features

Serial.Serial. Redeemed in installments. Redemption date Redeemed in installments. Redemption date

specified on bond itself.specified on bond itself. Convertible.Convertible.

Bondholder has the right to exchange bond for Bondholder has the right to exchange bond for specified # of shares of stock.specified # of shares of stock.

Subordinated.Subordinated. Claims are inferior to claims of general or secured Claims are inferior to claims of general or secured

creditors but take precedence over claims of creditors but take precedence over claims of shareholders.shareholders.

Zero coupon bonds.Zero coupon bonds. Callable.Callable.

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TermsTerms

Par value = face value = principal value = Par value = face value = principal value = maturity value.maturity value.

Coupon rate = stated interest rate.Coupon rate = stated interest rate. Interest payments = Face value * stated Interest payments = Face value * stated

interest rate.interest rate. Issuance costs: investment banking, Issuance costs: investment banking,

accounting, legal and printing fees.accounting, legal and printing fees. Deferred charges amortized over life of bonds Deferred charges amortized over life of bonds

using SL method.using SL method.

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Accounting for Bonds: Issuance Accounting for Bonds: Issuance at Par - No Issuance Costsat Par - No Issuance Costs

CashCash 100 100 Bonds payableBonds payable 100100

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Accounting for Bonds: Issuance Accounting for Bonds: Issuance at Par - With Issuance Costsat Par - With Issuance Costs

CashCash 100 100

Deferred charges - Deferred charges -

bond issuance costsbond issuance costs 5 5

Bonds payableBonds payable 105105

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Discount and PremiumDiscount and Premium

Higher risk, higher return expected by Higher risk, higher return expected by investors.investors. Higher interest rate, i.e., given a stated interest rate, Higher interest rate, i.e., given a stated interest rate,

lower selling price.lower selling price. Bonds issued for less (more) than stated value are Bonds issued for less (more) than stated value are

issued at a discount (premium).issued at a discount (premium). Zero coupon bonds = 0% interest rate, issued at Zero coupon bonds = 0% interest rate, issued at

deep discount.deep discount.

Original discount or premium = discount or Original discount or premium = discount or premium recorded by issuer.premium recorded by issuer.

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Issuing Bonds w/ Premium or Issuing Bonds w/ Premium or DiscountDiscount

Cash Cash 94 94

Bond DiscountBond Discount 6 6

Bonds payableBonds payable 100100

Cash Cash 103 103

Bonds payableBonds payable 100100

Bond premiumBond premium 3 3

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When a company issues a When a company issues a bond, what is it selling?bond, what is it selling?

Assume a company issues a $1,000, 5%, Assume a company issues a $1,000, 5%, 10 year bond, payments are semi-annual. 10 year bond, payments are semi-annual. What is the company selling?What is the company selling? Interest payments of $25 at the end of each of Interest payments of $25 at the end of each of

20 six month periods. (An ordinary annuity.)20 six month periods. (An ordinary annuity.) A lump-sum payment of $1,000 at the end of A lump-sum payment of $1,000 at the end of

10 years.10 years.

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Proceeds of Bond IssueProceeds of Bond Issue

If the (annual) market rate of interest is 6%, If the (annual) market rate of interest is 6%, what will proceeds be from the issuance of what will proceeds be from the issuance of 4000 bonds: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*14.87748=$1,487,7484000 bonds*$25*14.87748=$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*.553676=$2,214,7044000*$1,000*.553676=$2,214,704

Total = $1,487,748 + $2,214,704 = $3,702,452Total = $1,487,748 + $2,214,704 = $3,702,452

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Entry to Record IssuanceEntry to Record Issuance

CashCash 3,702,452 3,702,452

Bond DiscountBond Discount 297,548 297,548

Bonds PayableBonds Payable 4,000,000 4,000,000

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Book ValueBook Value

Net book value = principal plus Net book value = principal plus unamortized premium or less unamortized unamortized premium or less unamortized discount.discount.

Net carrying amount = book value less Net carrying amount = book value less unamortized deferred charges (issuance unamortized deferred charges (issuance costs).costs).

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Bond Interest ExpenseBond Interest Expense

2 components:2 components: Cash interest payments (usually semi-Cash interest payments (usually semi-

annual).annual). Amortization of bond premium or discount.Amortization of bond premium or discount.

GAAP requires the effective interest rate GAAP requires the effective interest rate method of amortization.method of amortization. SL method allowed only if it does not differ SL method allowed only if it does not differ

materially from effective interest rate method.materially from effective interest rate method.

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Effective Interest Rate MethodEffective Interest Rate Method

= compound interest rate = interest rate = compound interest rate = interest rate (method).(method).

Book value of bonds = market value = Book value of bonds = market value = cash value, necessarily, only at 2 points in cash value, necessarily, only at 2 points in time, when issued (BV = cash received) time, when issued (BV = cash received) and at maturity (BV = cash paid).and at maturity (BV = cash paid).

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Effective Interest Rate MethodEffective Interest Rate MethodBond Disc. Amortization TableBond Disc. Amortization Table

Beginning book value.Beginning book value. Bonds payable – unamort. Disc. (or + Prem.).Bonds payable – unamort. Disc. (or + Prem.).

Interest expense.Interest expense. Beginning book value * effective interest rate.Beginning book value * effective interest rate.

Interest paid.Interest paid. Face amount * stated interest rate.Face amount * stated interest rate.

Discount amortization.Discount amortization. Interest expense - interest paid.Interest expense - interest paid.

Ending book value.Ending book value. B. payable - new unamort. Disc. (or + Prem.).B. payable - new unamort. Disc. (or + Prem.).

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Retirement of BondsRetirement of Bonds

Bonds may be callable. A call premium Bonds may be callable. A call premium may be required.may be required.

Bonds could be purchased in the market Bonds could be purchased in the market and retired.and retired.

Gain (loss) = reacquisition price – net Gain (loss) = reacquisition price – net carrying amountcarrying amount

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Leased AssetsLeased Assets

Operating leases:Operating leases: Rent or leases in which payments are Rent or leases in which payments are

expensed.expensed. Capital or financing leases:Capital or financing leases:

Lessee effectively purchases asset.Lessee effectively purchases asset. Use of asset for its economic life is a purchase.Use of asset for its economic life is a purchase.

Lease is effectively an installment Lease is effectively an installment purchase or a financing tool. purchase or a financing tool.

Treated as a purchase of an asset and Treated as a purchase of an asset and the creation of a liability.the creation of a liability.

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Deferred Income TaxesDeferred Income Taxes

Arises when book income Arises when book income taxable taxable income.income.

Matching concept (or accrual income Matching concept (or accrual income concept):concept): Income tax expense is the amount that will Income tax expense is the amount that will

eventually be paid on the income recorded in eventually be paid on the income recorded in the books (i.e., on the IS) in the period.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 Difference between income taxes on book earnings

to date and income taxes on tax returns to date.to date and income taxes on tax returns to date.

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Analysis of Capital StructureAnalysis of Capital Structure

Invested capital = permanent capital = debt Invested capital = permanent capital = debt capital + equity capital.capital + equity capital.

Leverage = measure of soundness of Leverage = measure of soundness of company’s financial position.company’s financial position. Debt equity ratio = (total liabilities or non-current Debt equity ratio = (total liabilities or non-current

liabilities or interest bearing liabilities) liabilities or interest bearing liabilities) Shareholders’ equity.Shareholders’ equity.

Debt capitalization ratio = Debt / (Debt + Debt capitalization ratio = Debt / (Debt + shareholders’ equity).shareholders’ equity).

Times interest earned = interest coverage ratio = Times interest earned = interest coverage ratio = Pre-tax income before interest expense / interest Pre-tax income before interest expense / interest expense.expense.

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Bond RatingsBond Ratings

Indicates probability of going into default Indicates probability of going into default (not paying required interest or principal).(not paying required interest or principal).

Uses ratios such as debt-equity and other Uses ratios such as debt-equity and other information.information.

Bond rating agencies include:Bond rating agencies include: Standard & Poor’s.Standard & Poor’s. Moody’s.Moody’s.

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Discussion QuestionsDiscussion Questions

What has more risk: debt or equity What has more risk: debt or equity capital?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 Why do we use the term leverage for the debt-to-equity ratio? debt-to-equity ratio?