9.1: CHARACTERISTICS OF LONG-TERM NOTES AND BONDS PAYABLE

Question 1

What are the advantages of issuing long-term debt compared to issuing shares for companies like Amazon?

Answer 1

Shareholders maintain control as debtholders do not participate in management decisions.

Interest expense is tax deductible, reducing the net cost of borrowing.

Issuing bonds can increase the return to shareholders if borrowed funds are invested in high-return projects.

Question 2

How does the deductibility of interest for tax purposes impact the cost of borrowing for companies?

Answer 2

Interest expense being tax deductible reduces the net cost of borrowing, making it a favorable option for companies compared to non-deductible dividends.

Question 3

Why is it important for companies to maintain an appropriate balance between debt and equity capital in their capital structure?

Answer 3

Maintaining a balance ensures sound business practice. Companies need to optimize their capital structure to maximize returns to shareholders while minimizing financial risk.

Question 4

What are the two potential disadvantages of using long-term debt for a company?

Answer 4

Risk of bankruptcy: The company must make interest payments even if it incurs losses.

Negative impact on cash flows: Debt must be repaid in the future, requiring sufficient cash or the ability to refinance.

Question 5

How do lenders protect their interests in long-term debt agreements?

Answer 5

Lenders often request secured debt, allowing them to repossess specific assets (e.g., revenue, inventory, property) if the company violates the debt contract terms.

Question 6

What is the difference between secured and unsecured debt?

Answer 6

Secured debt: Lenders can repossess specific assets pledged as collateral in case of default.

Unsecured debt: Lenders cannot repossess specific assets; if the debtor defaults, the lender has no specific collateral to claim.

Question 7

What is a note payable, and how is it secured in the context of long-term debt agreements?

Answer 7

A note payable is a written promise to pay a stated sum of money at specified future dates.

Repayment is secured by the assets acquired with the borrowed funds.

Question 8

What types of assets can corporations like Amazon pledge as collateral for secured debt?

Answer 8

Corporations like Amazon can pledge revenue, inventory, property, equipment, and buildings as collateral for secured debt, providing creditors the right to foreclose and repossess these assets if contract terms are violated.

Question 9

What are the typical terms for loans, notes, and mortgage notes in the context of long-term debt agreements?

Answer 9

Loans and notes: Often for terms of five years or less.

Mortgage terms: Can exceed 25 years, allowing for a longer repayment period.

Question 10

What is private placement in the context of raising long-term debt, and what advantages does it offer to companies?

Answer 10

Private placement is when specific investors provide both debt and equity funds directly to a company.

It saves companies regulatory and filing fees and does not require disclosure of terms or funding sources.

Question 11

Why are private placements less liquid compared to other forms of debt like debentures and bonds?

Answer 11

Private placements are less liquid because the lack of a secondary market makes it difficult for sellers to find approved purchasers.

Securities laws limit participation in private placements, reducing their liquidity.

Question 12

What is a debenture, and how is it different from a bond in terms of collateral and trading?

Answer 12

Debenture: A debt instrument issued without collateral, possibly relying on revenue from a specific project. Repayment issues may arise if the project fails.

Bond: A debt instrument issued by public companies and governments with collateral to secure repayment. Bonds are publicly traded on regulated markets, providing liquidity to bondholders.

Question 13

How does the public trading of bonds and debentures contribute to their liquidity?

Answer 13

Bonds and debentures, when publicly traded on established secondary markets, provide holders with liquidity.

Public trading allows investors to buy and sell these instruments, enhancing their marketability.

Question 14

How does Amazon disclose information about its long-term debt, and what does the disclosure typically include?

Answer 14

Amazon discloses information about its long-term debt in documents such as Exhibit 9.2, listing the types of notes issued in the past.

The disclosure includes terms related to long-term debt, accounting practices, and financial issues associated with bonds.

Question 15

What are the key components of a bond, and what is the principal also known as?

Answer 15

Key components: Payment of interest over its life and repayment of principal on the maturity date.

Principal is also known as par value, face value, or maturity value.

Question 16

What is a bond’s coupon rate, and how is it related to periodic cash interest payments?

Answer 16

Coupon rate: The stated annual interest rate specified in the bond contract.

The periodic cash interest payment is computed as the bond’s face value multiplied by its coupon rate, adjusted for the frequency of interest payments (annual, semi-annual, or quarterly).

Question 17

Explain how a bond’s cash interest payment is calculated for different frequencies of interest payment.

Answer 17

Annual (once per year): Cash payment = $1,000 (face value) × 8% (coupon rate) = $80

Semi-annual (twice per year): Cash payment = $1,000 × 4% = $40 every six months

Quarterly (four times per year): Cash payment = $1,000 × 2% = $20 every three months

Note: The total annual interest payment remains constant at $80.

Question 18

What does the coupon rate represent, and why do different types of bonds have varying characteristics?

Answer 18

Coupon rate: The annual interest rate stated in the bond contract.

Different types of bonds have varying characteristics to cater to different investor preferences.

For example, secured bonds offer greater security by pledging specific assets, while convertible bonds allow conversion into common shares in the future.

Question 19

How do companies design bond features, and why is it comparable to automobile manufacturers designing cars for different consumer groups?

Answer 19

Companies design bond features to appeal to different groups of investors, similar to how automobile manufacturers design cars for different consumer preferences.

For instance, some investors may prioritize security and accept lower interest rates, while others may prefer the potential for conversion into common shares and accept lower interest rates in return.

Question 20

How is the times interest earned ratio calculated, and what does it indicate about a company’s financial health?

Answer 20

The times interest earned ratio is calculated as (Net earnings + Interest expense + Income tax expense) / Interest expense.

It indicates the amount of earnings before interest and tax expense generated for each dollar of interest expense.

A high ratio signifies an extra margin of protection in case profitability deteriorates, ensuring the company’s ability to meet required interest payments.

Question 21

Why is a high times interest earned ratio viewed more favorably than a low ratio?

Answer 21

A high ratio provides an extra margin of safety, indicating the company’s ability to cover interest payments even if profitability decreases.

It demonstrates financial stability and reduces the risk of bankruptcy, making it more favorable to investors and creditors.

Question 22

What caution should analysts exercise when interpreting the times interest earned ratio for new or rapidly growing companies?

Answer 22

For new or rapidly growing companies, the times interest earned ratio might be misleading because it can reflect significant interest expense associated with building capacity for future operations.

Analysts should consider the company’s long-term strategy and future earnings potential to make a more accurate assessment of the company’s financial health.

Question 23

Why do some analysts prefer using the cash coverage ratio over the times interest earned ratio, and what does the cash coverage ratio address?

Answer 23

Some analysts prefer the cash coverage ratio because it compares interest expense to the amount of cash a company can generate.

Creditors cannot be paid with “net earnings.”

The cash coverage ratio addresses this concern, providing a more direct assessment of a company’s ability to meet its interest obligations with available cash.