chapter 10: long term liabilities Flashcards
to which type of companies are long term liabilities advantageous?
companies in which:
shareholders maintain control
interest expense is tax deductible
the impact of earnings Is positive
what are the major disadvantages associated with long term debt?
risk of bankruptcy
negative impacts on cash flow (management must be able to repay the cash they borrowed without it hindering the cash they have)
what is the typical form of a single lender debt?
note payable
mortgage note payable
what is the typical form of a multiple lender debt
typically in the form of a debenture or a bond
what is a private placement?
having long term debt to pay to:
banks
insurance companies
pension fund companies
what are bonds and debentures used for?
obtain large sum of long term loan that cannot be lent by one single creditor
you have multiple creditors giving you the loan
what are the most common maturity dates for long term notes and loans?
usually 5 years or less
what are the most common maturity dates for mortgages?
usually exceeding 25 years
what is the general meaning of debt?
funds from creditors
what is the general meaning of equity?
funds from shareholders
what does it mean for a loan to be secured?
they have collaterals that can be liquidated in order to pay back the money they owe you if company that owes you goes broke
unsecured loan
you have no collateral, if they cant pay you, you lose the money
are bonds a secure loan or unsecured loan?
its secured
it means if you can’t pay up, you’re going to have to liquidate and pay them assets or cash form liquidation
are debentures a secure loan or unsecured loan?
they are not securitized
if somebody can’t pay, rip you
they are basically an unsecured bond
do bonds have interest to be also paid?
yeee
it is paid through principal at maturity
you pay interest and full amount
stated rate of interest always specified
what is a bond principal
the amount you have to pay at due date + periodic interest cash payments
what is the par value and face amount?
other names for bond principal or maturity value of bond
stated rate of interest
rate of interest per period specified in contract
what is a callable bond
bond may be called for early retirement by the issuer
Callable by the person who issued the contract, callable by company who issued the loan
redeemable bonds
You can pay back the loan to avoid paying additional interest
you do this when you don’t need the additional cash that accumulated interest
If you wanna redeem it, you could end up paying some additional interest for breaking the contract
retractable bonds
If you are to retract it early, youre not getting the full amount (as the one who gave the loan)
convertible bonds
bonds may be converted into common shares by the issuer
what is a bond indenture?
bond contract that specifies the legal provisions of bonds
contains covenants designed to protect the creditors
when does a company prepare bond indentures
when it issues new bonds
what do typical covenants include
energy swords
limitations on new debt that the company might issue in the future
limitations on payments of dividends
required minimum levels of accounting ratios
manager prefer which types of covenants
those that glass reach
those that are less restrictive to not reduce company’s future actions
what type of covenants do creditors prefer
restrictive covenants to reduce risk of losing their investment
where are covenants usually reported
in the notes of the financial statements
what is a bond certificate
the bond document that a bondholder re¡receives when the bond is issued
all bond certificates for a single bond are identical
what is the trustee?
independent party appointed to represent bondholders
firm commitment underwriter
buys entires issues of bonds and resells them to individual creditors
best efforts underwriter
just sells bonds or notes without any obligation to purchase them
over-the-counter market (OTC)
this is where most bonds are traded
basically, they are traded by telephone
default risk of a bond
evaluating the a probability that a bond issuer will not be able to meet the requirements specified in the indenture
the higher the risk default the higher or lower the interest rate of a bond?
the higher the interest rate of a bond
what are the two main reasons that bonds change prices?
changes in creditworthiness of bond issues
changes in market interests
cash interest payments
multiplying the principal amount and the interest rate (coupon rate)
coupon rate
stated rate of interest on bonds
the market interest rate
the current rate of interest when incurred
also called yield or effective interest rate
bond premium
the difference between selling price and par
occurs when sold for above par
interest rate higher than market interest rate
bond discount
the difference between selling price and par
occurs when sold for below par
interest rate lower than market interest rate
why are creditors indifferent if a bond is used as par, discount, or premium?
because bonds are always priced to provide the market rate of interest
how are the effective and stated rate of interest when the present value of the future cash flows associated with a bond is equal to the bond’s par value?
the effective and stated rate of interest are equal
true or false
companies rarely issue bonds at par
true
effective interest method
amortizes a bond discount, or premium, on the basis of the tinters rate
what are the steps to the effective interest method?
step 1: compute the interest expense
unpaid balance * effective interes trates * n/12
n = number of months in each interest period
step 2: compute the amortization amount:
amortization of bond discount = interest expense - interest paid (accrued)
amortization of bond premium = interest expense - interest paid (accrued)
what do you do you do to discounts or amortization on bonds payable?
it adds to the carrying amount of the loan, hence interest expense increases at every period of payment
the carrying amount increases every period, until it goes makes the whole thang equal to the stated price of the bond
bonds are recorded at full value of payment or present value?
present value with current market rate of interest
what is a zero coupon bond
bonds that do not pay periodic cash interest
will sell at much less than its maturity value because it does not carry any interest
when are bonds sold at premium?
when market rate of interest is lower than the bond interest rate
when bonds are sole at premium, does the interest expense increase or decrease every period that you have to pay? why?
it decreases
the carrying amount of the present value is bigger than future cash flows
so to get to the same amount of future cash flows, the amortization is taken off the carrying amount at every payment instead of added to it
when bonds or sold at premium, in every payment, does amortization increase or decrease?
they increase as well
instead of adding it to carrying amount, they take it off
where is the interest expense reported?
in the statement of financial earnings
what is the times interest earned ratio?
meaning and formula
is the company generating enough ressources (added value) from profit making activities to meet is current obligations associated with debt?
higher ratio is gayer because it is an extra margin of protection in case profitability deteriorates
want to see if you can meet required interest payments and obligations
interest expense
what could cause the price of a bond to drop?
a rise in interest rates
what would be the result of repurchasing a bond when interest rates rise?
it would result in a gain that increase the company’s net earnings
what happens if you decide to retire a bond because of rising interest rates but decide to sell if after at a higher contract interest (not the same as market interest)
the gain made on the retirement of the bond would be misleading
company will need to make higher interest payments not the refinanced debt
If you decide to retire a bond when market interest rates decrease, what will it result in?
a loss on statement of earnings
it will reduce the amount of periodic interest payments
what is an operating lease
leasing an asset without transferring or risks and rewards to lessee
no liability is recorded when operating lease is created
rent expense is recorded when the use the asset
what is a finance lease
a lease that transfers all the risks and rewards of ownership from lessor to lessee
you record it as if an asset was purchased
you record the asset and the liability to pay
what are the terms to consider a lease a finance lease
ownership of the asset is transferred to lessee at end of the lease term
lease contract provides lessee with option to purchase the asset in the future at a price that is expected to be sufficiently lower than its fair market value at the time the option becomes possible to activate
the lease term is a major part of the asset’s economic life even if the title is not transferred
lessee only one that can use assets without any major modifications
present value of the minimum lease payments is substantially all of the fair value of the leased asset when the lease is signed
debt to equity ratio
explain and formula
to examine company’s financing strategy
to examine how much debt has been used to finance a company’s acquisition of assets in comparison to investments by shareholders
high ratio indicates that they rely heavily on creditors and less from investors
assess the risk that company may not be able to meet its financial obligations during business downturn
debt to equity ratio = total liabilities / shareholder’s equity
which more company would prove to be more risky for creditors and investors?
high debt to equity ratio and high interest coverage ratio
low debt to equity ratio and low interest coverage ratio
low debt to equity ratio and low interest coverage ratio
any amount of liability can be risky, so even if its small, there is a chance the company can’t pay it
the company with hight interest coverage ratio is viewed as less risky than one with low interest coverage ratio (even if it has high debt to equity ratio)
what is the difference between stated interest and the effective rate of interest on a bond?
The stated rate of interest is the rate specified on a bond;
it is the basis for determining interest payment to the bondholders
The effective rate of interest is the market rate at which the bonds are selling currently;
it determines the effective overall interest on the bond
straight line amortization
simplified bond amortization method that allocates an equal amount to each interest period
