1. Copyright 2003 Prentice Hall Publishing Company 1 Chapter 8 Special Acquisitions: Financing A Business with Debt

2. Copyright 2003 Prentice Hall Publishing Company 2 Business Background Capital structure is the mix of debt and equity used to finance a company. DEBT: Loans Loans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital. Bonds Bonds are debt securities issued when borrowing large amounts of money. Can be issued by either corporations or governmental units.

3. Copyright 2003 Prentice Hall Publishing Company 3 Notes Payable and Mortgages  When a company borrows money from the bank for longer than a year, the obligation is called a long- term note payable.  A mortgage is a special kind of “note” payable--one issued for property.  These obligations are frequently repaid in equal installments, part of which are repayment of principal and part of which are interest.

4. Copyright 2003 Prentice Hall Publishing Company 4 How Borrowing Money With A Long-term Note Affects The Accounting Equation When the note is issued (when the money is borrowed): Assets = Liabilities + OE + cash = + N/P

5. Copyright 2003 Prentice Hall Publishing Company 5 How Borrowing Money With A Long-term Note Affects The Accounting Equation When a payment (that is MORE than the interest) is made: Assets = Liabilities + OE -cash-N/P- interest expense (a little part) (for the period)

6. Copyright 2003 Prentice Hall Publishing Company 6 Time Value of Money  The example of the mortgage demonstrates that money has value over time.  When you borrow $100,000 and pay it back over three years, you have to pay back MORE than $100,000.  Your repayment includes interest--the cost of using someone else’s money.  A dollar received today is worth more than a dollar received in the future.  The sooner your money can earn interest, the faster the interest can earn interest.

7. Copyright 2003 Prentice Hall Publishing Company 7 Interest and Compound Interest  Interest is the return you receive for investing your money. You are actually “lending” your money, so you are paid for letting someone else use your money.  Compound interest -- is the interest that your investment earns on the interest that your investment previously earned.

8. Copyright 2003 Prentice Hall Publishing Company 8 ? Future Value of a Single Amount How much will today’s dollar be worth in the future? TODAYFUTURE

9. Copyright 2003 Prentice Hall Publishing Company 9  The previous example had a single payment. Sometimes there is a series of payments.  Annuity: a sequence of equal cash flows, occurring at the end of each period.  When the payments occur at the end of the period, the annuity is also known as an ordinary annuity.  When the payments occur at the beginning of the period, the annuity is called an annuity due. The Value of a Series of Payments

10. Copyright 2003 Prentice Hall Publishing Company 10 What An Annuity Looks Like 01 234

11. Copyright 2003 Prentice Hall Publishing Company 11 How much is $1 received in the future worth today? (COMPOUNDING) Figuring out how much a future amount is worth TODAY is called DISCOUNTING the cash flow. Present Value of a Single Amount ? TODAYFUTURE

12. Copyright 2003 Prentice Hall Publishing Company 12  Finding the present value of a series of cash flows is called discounting the cash flows.  What is the series of future payments worth today? 01 234 Present Value of an Annuity

13. Copyright 2003 Prentice Hall Publishing Company 13 Characteristics of Bonds Payable principal  Bonds usually involve the borrowing of a large sum of money, called principal. lump sum  The principal is usually paid back as a lump sum at the end of the bond period. par valueface value  Individual bonds are often denominated with a par value, or face value, of $1,000.

14. Copyright 2003 Prentice Hall Publishing Company 14 stated rate of interest  Bonds usually carry a stated rate of interest.  Interest is normally paid semiannually.  Interest is computed as: Interest = Principal × Stated Rate × Time Characteristics of Bonds Payable

15. Copyright 2003 Prentice Hall Publishing Company 15 Bonds $1,000--principal 10%--interest rate (annual) 5yrs.--time to maturity annual---interest payments This is the information shown on a bond certificate... The cash flows associated with the bonds are defined by the terms on the face of the bond.

16. Copyright 2003 Prentice Hall Publishing Company 16 bond certificate  The new bondholder receives a bond certificate.  Identifies the par value, the stated interest rate, the interest dates, and the maturity date. trustee bond indenture,  The trustee makes sure the issuing company fulfills all of the provisions of the bond indenture, or agreement. Characteristics of Bonds Payable

17. Copyright 2003 Prentice Hall Publishing Company 17 Bond Classifications  Unsecured bonds  Unsecured bonds (also called debentures) do not have pledged assets as a guarantee of repayment at maturity.  Secured bonds  Secured bonds include a pledge of specific assets as a guarantee of repayment at maturity.

18. Copyright 2003 Prentice Hall Publishing Company 18 Bond Classifications  Ordinary bonds  Ordinary bonds (also called single-payment bonds)  The full face amount is paid at the maturity.  Serial bonds  The principal is paid in installments on a series of specified maturity dates.

19. Copyright 2003 Prentice Hall Publishing Company 19 Bond Classifications  Callable bonds  May be retired and repaid (called) at any time at the option of the issuer.  Redeemable bonds  May be turned in at any time for repayment at the option of the bondholder.  Convertible bonds  May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder.

20. Copyright 2003 Prentice Hall Publishing Company 20 Bond Classifications  Registered bonds  Payment of interest is made by check and mailed directly to the bondholder whose name must be registered.  Coupon bonds  Coupons are attached to the bond for each interest payment.  The bondholder “clips” each coupon and presents it for payment on the interest date.

21. Copyright 2003 Prentice Hall Publishing Company 21 Measuring Bonds Payable and Interest Expense market interest rate  The interest rate used to compute the present value is the market interest rate.  Also called yield, effective rate, or true rate.  Creditors demand a certain rate of interest to compensate them for the risks related to bonds. stated ratecoupon rate  The stated rate, or coupon rate, is only used to compute the periodic interest payments.

22. Copyright 2003 Prentice Hall Publishing Company 22 Determining the Selling Price  Bonds sell at:  “Par” (100% of face value)  less than par (discount)  more than par (premium)  Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond)  Therefore, if  market % > stated %: Discount  market % < stated %: Premium

23. Copyright 2003 Prentice Hall Publishing Company 23 Finding The Proceeds Of A Bond Issue  To calculate the issue price of a bond, you must find the present value of the cash flows associated with the bond.  First, find the present value of the interest payments using the market rate of interest. Do this by finding the PV of an annuity.  Then, find the present value of the principal payment at the end of the life of the bonds. Do this by finding the PV of a single amount.

24. Copyright 2003 Prentice Hall Publishing Company 24 The PV of the future cash flows = issue price of the bonds  The present value of these cash flows will be the issue price of the bonds.  That is the amount of cash the bondholders are willing to give TODAY to receive these cash flows in the future.

25. Copyright 2003 Prentice Hall Publishing Company 25 Carrying Value Of BONDS PAYABLE While the specific long-term liability Bonds Payable is always recorded (and kept) at face value, the Discount or Premium (on Bonds Payable) will be either subtracted (discount) or added (premium) to the BP amount to get the carrying value of the bond at any given date.

26. Copyright 2003 Prentice Hall Publishing Company 26 Effective Interest Method For Amortizing A Bond Discount If we prepared a balance sheet on the date of issue, the bond would be reported like this: Bonds Payable $ 1,000,000 less Discount on B/P (130,000) Net Bonds Payable 870,000

27. Copyright 2003 Prentice Hall Publishing Company 27 Effective Interest Method For Amortizing A Bond Discount  The discount is a contra-liability (and is deducted from the face value of the bond to give the “book value.”)  In order to get the book value to equal the face value at maturity, we’ll have to get rid of the balance in the discount account.  Each time we pay interest to our bondholders, we’ll amortize a little of the discount.

28. Copyright 2003 Prentice Hall Publishing Company 28 Effective Interest Method For Amortizing A Bond Discount  Each time we pay interest to our bondholders, we’ll amortize a little of the discount--how much?  Amortizing a bond discount increases interest expense  On the first interest date, the amount we’ve actually “borrowed” from the bondholders is $870,000.  The market rate at the time we borrowed--the rate we had to pay to get the bondholders to buy our bonds-- was 8%.  870,000 x.08 x 1/2 = 34,800 (This will be the interest expense for the first 6 months.)

29. Copyright 2003 Prentice Hall Publishing Company 29 Effective Interest Amortization of Bond Discount We know the cash payment to the bondholders is $30,000: 1,000,000 x.06 x 1/2 par value interest 6-month period rate

30. Copyright 2003 Prentice Hall Publishing Company 30 Effective Interest Amortization of Bond Discount The difference between the interest expense of $34,800 and the cash payment to the bondholders of $30,000 is the amount of discount amortization. $34,800 - 30,000 $ 4,800 This amount will be deducted from the discount.

31. Copyright 2003 Prentice Hall Publishing Company 31 Next Time --  When we calculate the amount of interest expense for the second interest payment, our principal balance has changed.  Instead of 870,000, we now have a principal balance of 874,800. Why?  874,800 x.08 x 1/2 = $34,992  This is the interest expense for the second six-month period.

32. Copyright 2003 Prentice Hall Publishing Company 32 Measuring and Recording Interest on Bonds Issued at a Premium amortized  The premium must be amortized over the term of the bonds. interest expense  The premium amortization decreases the periodic interest expense for the issuer.  Two methods are commonly used:  Effective-interest amortization  Straight-line amortization

33. Copyright 2003 Prentice Hall Publishing Company 33  When a bondholder sells a bond, there is no effect on the books of the issuing company.  Bondholders trade among themselves in the bond market.  Changes in the market rate of interest and the risk related to specific bonds cause the prices of bonds to change. Trading Bonds

34. Copyright 2003 Prentice Hall Publishing Company 34 Financial Analysis debt-equity ratio  The debt-equity ratio is an important measure of the state of a company’s capital structure. tight cash flow  When a company’s debt-equity ratio is excessive, a large amount of fixed debt payments may cause problems in tight cash flow periods. Debt-Equity Ratio = Total Debt ÷ Total Equity