Chapter 9 Non-owner Financing

Accounting Equation: Another Look

Debt, Leverage, and Risk Magnitude of required debt payments increases proportionally with the level of debt financing, and more required debt payments implies a higher probability of default should a downturn in business occur. Increasing levels of debt, then, makes the firm look riskier to investors who, consequently, demand a higher return on the capital they provide to the company.

Long-Term Financing Companies typically require long-term liabilities in their capital structure to support long-term asset acquisitions and maintenance. Bonds and notes are structured like any other borrowing - the borrower receives cash and agrees to pay it back along with interest.

Bonds Payable Terminology Life, Maturity date Face value, principal, par value, maturity value Interest payment Proceeds at issuance Interest rate Coupon or stated Market or effective Other provisions Call (redemption) provision

Bond Pricing There are two different interest rates you must understand before we can discuss the mechanics of bond pricing: Coupon (contract or stated) rate – the stated rate in the bond contract. It is used to compute the dollar amount of (semiannual) interest payments that are paid to bondholders during the life of the bond issue. Market (yield) rate – the interest rate that investors expect to earn on the investment in the debt security. This rate is used to price the bond issue (.i.e, the discount rate in the PV calculation)

Coupon Rate vs. Market Rate

When a company issues a bond, what is it selling? Assume a company issues a $1,000, 5%, 10 year bond, payments are semi-annual. What is the company selling? Interest payments of $25 at the end of each of 20 six month periods. (An ordinary annuity.) A lump-sum payment of $1,000 at the end of 10 years.

Cash Flows from Bonds Bondholders normally expect to receive two different cash flows: Periodic (usually semiannual) payments of interest during the bond life. These payments are often in the form of equal cash flows at periodic intervals, called an annuity. Single payment of the face (principal) amount of the bond at maturity.

Cash Flows from Bonds To illustrate, assume that investors wish to price a bond with a face amount of $10 million, an annual coupon rate of 6% payable semiannually (3% semiannual rate), and a maturity of 10 years. Investors purchasing this issue will receive the following cash flows:

Bond Pricing: Coupon Rate = Market Rate (Par) Company promises to pay 20 semiannual payments of $10 million  (6%/2) = $300,000 each, plus the $10 million face amount of the bond at maturity, for a total of $16 million. Assuming that investors desire a 6% annual market rate of interest (yield), the bond sells for $10 million:

Bond Pricing: Coupon Rate < Market Rate (Discount) Assume that the company is not viewed as an acceptable credit risk and, to compensate for accepting a higher level of risk, investors expect an 8% annual yield (4% semi-annual yield). Given this new discount rate, the bond will sell for $8,640,999:

Bond Pricing: Coupon Rate > Market Rate (Premium) Assume that investors expect only a 4% annual yield (2% semiannual yield). Given this new discount rate, the bond sells for $11,635,129 – see below:

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

Bond Interest Expense 2 components: Cash interest payments (usually semi-annual). Amortization of bond premium or discount. GAAP requires the effective interest rate method of amortization.

Effective Interest Rate Actual rate paid by issuer May or may not be same as the stated rate Determined by discount rate that sets the present value of the future cash outflows equal to the fair market value of that which is received in the exchange.

Effective Interest Rate Method Bond Disc. Amortization Table Beginning book value. Bonds payable – unamort. Disc. (or + Prem.). Interest expense. Beginning book value * effective interest rate. Interest paid. Face amount * stated interest rate. Discount amortization. Interest expense - interest paid. Ending book value. B. payable - new unamort. Disc. (or + Prem.).

Accounting for Long-Term Obligations Record the asset acquired in the exchange at its fair market value. Record the obligation at its face value. Record a discount or premium if the obligation is different than the fair market value of the asset acquired. Record interest expense for each period: effective interest rate x balance sheet value of the obligation at the beginning of the period.

Accounting for Bonds: Income Statement Interest expense in the income statement is the sum of two components: Amortization of a discount adds to the cash interest paid to compute interest expense. Amortization of a discount reflects additional cost the company incurs upon sale of the bonds; and, recognition of this cost through its amortization yields increased interest expense. Conversely, a premium is a benefit the company receives at issuance of a bond; and, amortization of a premium yields reduced interest expense.

Effective Interest Method (Discount Example) Companies amortize the discount and premium using the effective interest method

Effective Interest Method (Premium Example)

Gain (Loss) on Repurchase of Bonds Purchase of a bond is like the sale of a long-term asset A gain or loss can result from a repurchase. Book value of the bond is the net amount that appears on the balance sheet. If the company pays more to retire the bonds than they carry on the balance sheet, this is a cost that is reflected in the income statement as a loss on retirement of bonds. Conversely, a company reports a gain on retirement of bonds if the purchase price is less than its book value.

Off-Balance Sheet Financing Off-balance sheet financing means that either liabilities are kept off of the face of the balance sheet. In this chapter we discuss leases. Variable interest entities (called SPEs in the past) were previously discussed when we covered the equity method of accounting.

Motives for using Off-Balance Sheet Financing In general, companies desire to present a balance sheet with sufficient liquidity and less indebtedness. The reasons for this are as follows: liquidity and the level of indebtedness are viewed as two measures of solvency. Companies that are more liquid and less highly financially leveraged are generally viewed as less likely to go bankrupt. As a result, the risk of default on their bonds is less, resulting in a higher rating on the bonds and a lower interest rate.

Leasing A lease is a contact between the owner of an asset (the lessor) and the party desiring to use that asset (the lessee). Generally, leases provide for the following terms: The lessor allows the lessee the unrestricted right to use the asset during the lease term The lessee agrees to make periodic payments to the lessor and to maintain the asset Title to the asset remains with the lessor, who usually retakes possession of the asset at the conclusion of the lease.

Advantages to Leasing Leases often require much less equity investment than bank financing. Since leases are contracts between two willing parties, their terms can be structured in any way to meet their respective needs. If properly structured, neither the leased asset not the lease liability are reported on the face of the balance sheet.

Operating Lease Operating lease method. Under this method, neither the lease asset nor the lease liability is on the balance sheet. Lease payments are recorded as rent expense when paid.

Operating Leases Leased asset is not reported on the balance sheet. Lease liability is not reported on the balance sheet. For the early years of the lease term, rent expense reported for an operating lease is less than the depreciation and interest expense reported for a capital lease.

Capital vs. Operating Leases Capital lease method. This method requires that both the lease asset and the lease liability be reported on the balance sheet. The leased asset is depreciated like any other long-term asset. The lease liability is amortized like a note, where lease payments are separated into interest expense and principal repayment.

Capital vs. Operating Leases The benefits of applying the operating method for leases are obvious to managers. The lease accounting standard, unfortunately, is structured around rigid requirements. Whenever the outcome is rigidly defined, clever managers that are so-inclined can structure lease contracts to meet the letter of the standard to achieve a desired accounting result when the essence of the transaction would suggest a different result. This is form over substance.

Capital Leases Capital leases Effectively an installment purchase Lessee assumes rights and risks of ownership Treated as purchases Examples of what constitutes a capital lease PV of lease payments is the FMV of the asset Period of the lease approximates the assets life There is a bargain purchase price

Footnote Disclosures of Lessees

Capitalizing Operating Leases for Analysis Purposes Determine the discount rate to compute the present value of the operating lease payments. This can be inferred from the capital lease disclosures, or one can use the company’s debt rating and recent borrowing rate for intermediate term secured obligations as disclosed in its long-term debt footnote. Compute the present value of the operating lease payments. Add the present value computed in step 2 to both assets and liabilities.

Capitalization of Midwest Air Operating Leases