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

Copyright 2003 Prentice Hall Publishing Company

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Chapter 8 Chapter 8

Special Acquisitions: Financing A Business with Debt


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Business BackgroundBusiness BackgroundCapital structure is the mix of debt and equity

used to finance a company.

DEBT:LoansLoans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital.BondsBonds are debt securities issued when borrowing large amounts of money.

Can be issued by either corporations or governmental units.


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Notes Payable and MortgagesNotes 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.


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How Borrowing Money With A How Borrowing Money With A Long-term Note Affects The Long-term Note Affects The Accounting EquationAccounting Equation

When the note is issued (when the money is borrowed):

Assets = Liabilities + OE + cash = + N/P


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How Borrowing Money With A How Borrowing Money With A Long-term Note Affects The Long-term Note Affects The Accounting EquationAccounting 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)


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Time Value of MoneyTime 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.


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Interest and Compound InterestInterest 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.


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Future Value of a Future Value of a Single AmountSingle AmountHow much will today’s dollar be worth in the future?

TODAY FUTURE


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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 PaymentsThe Value of a Series of Payments


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What An Annuity Looks Like

0 1 2 3 4


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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 AmountPresent Value of a Single Amount

?TODAY FUTURE


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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?

0 1 2 3 4

Present Value of an AnnuityPresent Value of an Annuity


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Characteristics of Bonds PayableCharacteristics of Bonds Payable

Bonds usually involve the borrowing of a large sum of money, called principalprincipal.

The principal is usually paid back as a lump sumlump sum at the end of the bond period.

Individual bonds are often denominated with a par valuepar value, or face valueface value, of $1,000.


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Bonds usually carry a stated rate of stated rate of interestinterest.

Interest is normally paid semiannually. Interest is computed as:

Interest = Principal × Stated Rate × Time Interest = Principal × Stated Rate × Time



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BondsBonds

$1,000--principal10%--interest rate (annual)

5yrs.--time to maturityannual---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.


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The new bondholder receives a bond certificatebond certificate. Identifies the par value, the stated

interest rate, the interest dates, and the maturity date.

The trusteetrustee makes sure the issuing company fulfills all of the provisions of the bond indenture,bond indenture, or agreement.



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Bond ClassificationsBond Classifications

Unsecured bondsUnsecured bonds (also called debentures) do not have pledged assets as a guarantee of repayment at maturity.

Secured bondsSecured bonds include a pledge of specific assets as a guarantee of repayment at maturity.


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Ordinary bondsOrdinary bonds (also called single-payment bonds) The full face amount is paid at

the maturity. Serial bondsSerial bonds

The principal is paid in installments on a series of specified maturity dates.


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Callable bondsCallable bonds May be retired and repaid (called) at any time

at the option of the issuer. Redeemable bondsRedeemable bonds

May be turned in at any time for repayment at the option of the bondholder.

Convertible bondsConvertible bonds May be exchanged for other securities of the

issuer (usually shares of common stock) at the option of the bondholder.


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Registered bondsRegistered bonds Payment of interest is made by check

and mailed directly to the bondholder whose name must be registered.

Coupon bondsCoupon 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.


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Measuring Bonds Payable and Measuring Bonds Payable and Interest ExpenseInterest Expense

The interest rate used to compute the present value is the market interest ratemarket 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.

The stated ratestated rate, or coupon ratecoupon rate, is only used to compute the periodic interest payments.


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Determining the Selling PriceDetermining 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


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Finding The Proceeds Of A Bond IssueFinding 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.


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The PV of the future cash flows The PV of the future cash flows = issue price of the bonds= 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.


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Carrying Value Of BONDS Carrying Value Of BONDS PAYABLEPAYABLE

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.


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Effective Interest Method For Effective Interest Method For Amortizing A Bond DiscountAmortizing 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


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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.


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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.)


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Effective Interest Amortization Effective Interest Amortization of Bond Discountof 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

periodrate


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Effective Interest Amortization Effective Interest Amortization of Bond Discountof 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.


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Next Time --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.


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Measuring and Recording Interest Measuring and Recording Interest on Bonds Issued at a Premiumon Bonds Issued at a Premium

The premium must be amortizedamortized over the term of the bonds.

The premium amortization decreases the periodic interest expenseinterest expense for the issuer.

Two methods are commonly used: Effective-interest amortization Straight-line amortization


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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 BondsTrading Bonds


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Financial AnalysisFinancial Analysis

The debt-equity ratiodebt-equity ratio is an important measure of the state of a company’s capital structure.

When a company’s debt-equity ratio is excessive, a large amount of fixed debt payments may cause problems in tight tight cash flowcash flow periods.

Debt-Equity Ratio = Total Debt ÷ Total Equity

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

Documents

borrowing money

debt slide

period slide

np slide

elses money

time value of money

todayfuture slide

large amounts of money