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Sources of Capital: Debt: Mcgraw-Hill/Irwin

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46 views

Sources of Capital: Debt: Mcgraw-Hill/Irwin

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Uploaded by

Melissa Anderson
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© © All Rights Reserved
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You are on page 1/ 24

Chapter 8

Sources of
Capital: Debt

McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Liability
Obligation to an outside party.
Arises from a transaction or an
event that has already
happened.
Some not legally enforceable:
E.g., Allowance for Warranties.

8-2

Legal Obligations
That Are Not
Accounting Liabilities
Executory contracts.
Contracts in which neither party
has yet performed.
Contract to pay a baseball player $1
million per year for five years.
A contract to provide legal services
next year.

8-3

Are These Liabilities?


Receive $50,000 retainer for legal
services to be performed on an asneeded 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.
$1,000,000 product liability suit
against company. Is probable will
lose suit.
8-4

Contingencies
Uncertainty as to possible gain or
loss that will ultimately be resolved
by some future event.
Gain contingencies.
Usually not reported (conservatism
concept).

Loss contingencies.
Conditions present determine if
recorded.
8-5

Loss Contingency
Record if:
Probable an asset impaired or liability
incurred.
Can be reasonably estimated.

Disclose if:
Only reasonably possible, and/or,
Cannot be reasonably estimated.

No disclosure if possibility is remote.


8-6

Sources of funds
Debt capital (this chapter).
Obtained from borrowing (i.e.,
creditors).

Equity capital (Chapter 9).


Obtained from shareholders.
Direct contribution (paid-in capital).
Indirect contribution (retained
earnings).
8-7

Debt Capital
Debt instruments.
Term loans.
Repayable according to a specified schedule.
For major corporations, bonds more
prevalent.

Bonds.
Certificate promising to pay its holder:
Specified sum of money at a stated date, and
Interest at a stated rate until maturity.

Price usually quoted as % of face value (e.g.,


98, 102).
8-8

Bonds
Bond indenture.
Bond agreement.
May contain covenants (e.g., maintaining
certain minimum financial ratios).

Variable rate bond.

Interest rate varies, usually with prime


rate.

Mortgage bond.

Secured by pledged assets.

Debenture bond.

Not secured by specific assets.


8-9

Bonds
Sinking fund bonds.
Covenant that requires setting aside
cash/investments to be used to redeem
bonds at maturity (or at regular
intervals).

Serial bonds.
Redeemed in installments (redemption
date specified on bond).

Callable bonds.
Option of issuing entity to redeem
before maturity.

8-10

Bonds
Zero coupon bonds.
Issued at deep discount.
No interest is paid.

Convertible bonds.
Bondholder has the right to exchange
bond for specified number of common
shares.

Subordinated.
Claims are inferior to claims of general or
secured creditors, but take precedence
over claims of shareholders.
8-11

Bond Terminology
Par value.
Also called face value, principal value,
maturity value.

Coupon rate.
Stated interest rate.

Interest payments.
Face value * Stated interest rate.

Market rate.
Prevailing interest rate for a given
financial instrument.
8-12

Bond Terminology
Bond issuance costs.
E.g., investment banking, accounting, legal,
printing.
Recorded as a deferred charge.
Amortized to expense over life of bond.

Bond discount.
Occurs when market rate is higher than coupon
rate.

Bond premium.
Occurs when market rate is lower than coupon
rate.
8-13

Bond Terminology
Net book value.
Principal, less unamortized discount (or
plus unamortized premium).

Net carrying amount.


Book value less unamortized deferred
charges (issuance costs).

8-14

Bond Issue Price


Two components:
1. Present value of principal.
2. Present value of interest payments.

Present value calculations are


based on market rate of interest.
The difference between the issue
price and the par value is the
amount of discount or premium.
8-15

Accounts Used For


Bonds
Bonds Payable.
Liability, par (maturity) value of bonds.

Bond Discount.
Contra-liability account (i.e., subtract
from Bonds Payable on Balance Sheet).

Bond Premium.
Adjunct-liability account (i.e., add to
Bonds Payable on balance sheet).
8-16

The Life of a Bond


1.Issuance.
Record liability (i.e., Bonds
Payable)
Record Bond Discount or Bond
Premium.
Record Deferred Charges.

8-17

The Life of a Bond


2. Bond Interest Expense entries.
Usually semi-annual.
Consists of:
Cash interest payments (i.e., Face value
Stated interest rate), and
ADD bond discount amortization, or
SUBTRACT bond premium amortization.

May need adjusting entry if bond interest


payment date does not match end of
period.
8-18

The Life of a Bond


3.Retirement.
Before maturity (i.e., callable or
purchased in market).
Gain (loss) = Reacquisition price Net
carrying amount.

At maturity.
Zero ($0) balance in Deferred
Charges, Bond Discount (or Bond
Premium) because of amortization.
Debit Bonds Payable, credit Cash.
8-19

Bond Interest
Expense: Additional
Considerations

Effective interest method.

Required method to compute bond interest


expense (and discount/premium
amortization).
Straight-line method allowed (if results not
materially different).
Bond interest expense = Book value * Market
rate.
Book value continuously changing (i.e., increasing
with discount, decreasing with premium).
Market rate at bond issuance (i.e., remains
constant).
8-20

Capital Lease
Called finance lease by IFRS.
Meets certain criteria which requires it
to be recorded as a capital lease
(rather than as an operating lease).
Treated as a purchase of an asset and
creation of a liability.

Treated similar to an installment purchase.


Capital lease obligation (liability) is lower
of fair value or present value of minimum
lease payments.
Asset depreciated; interest paid on
obligation.
8-21

Analysis of Capital
Structure
Invested (permanent) capital.
Debt capital + Equity capital.

Leverage.
Based on the use of debt capital.
A measure of the soundness of a
companys financial position.
Risk vs. cost.

8-22

Analysis of Capital
Structure: Measuring
Leverage

Debt/equity ratio.

Debt Shareholders equity.


Debt can be total liabilities or just longterm liabilities.

Debt/capitalization ratio.
Debt (Debt + Shareholders equity).

Times interest earned (i.e., interest


coverage).
Pre-tax income before interest expense
Interest expense.
8-23

Bond Ratings
Indicates probability of going
into default (i.e., not paying
interest or principal as due).
Factors considered include ratio
analysis, industry analysis,
companys market position.
Bond rating agencies include
Standard & Poors, Moodys.
8-24

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