Chapter 14 Bonds and Long-Term Notes

Question 1

For all long-term borrowings, disclosures should include aggregate amount maturing and sinking fund requirements for how long?

Answer 1

the next five years.

Question 2

To evaluate a firm’s risk

Answer 2

Calculate debt ratio

Total liabilities/shareholder’s Equity

Question 3

Creditors will be concerned with which ratios?

Answer 3

Time Interest:

(Net Income + Interest amount+ Taxes)/Interest amount

this measures the amount of confidence a creditor has in the people that borrow the money

Question 4

I am looking to invest in a co. Which ratios do I use?

Answer 4

1. Debt Ratio to show risk* note: debt isn’t always a bad thing because it could use leverage.
2. Rate of Return on Assets

net income/total assets

This shows profitability (but it doesn’t take into account the financing (borrowing)

3. Rate of return on Equity

Net income/Shareholder’s Equity

This indicates effectiveness of using the resources from the owners

NOTE: if 3 > 2, management is leveraging, using debts to enhance the earnings for shareholders.

Question 5

When is debt an advantage?

Answer 5

When leveraging occurs, using debts to enhance shareholders earnings

Question 6

for early extinguishment of Debt (paying off early) the difference in the outstanding debt and the amount paid is recognized as…

Answer 6

a gain or loss

Question 7

What are convertible bonds (CV’s)?

Answer 7

bonds that can be converted (exchanged for) shares of stock at the option of the bondholder. Therefore these bonds have features of both debt (recorded in bond accounts) and equity (conversion amount in equity account..

Benefit for Investor: though a lower return rate, it is stock with a bond option inside it. Can be converted to stock at the owner’s discretion

Benefit for issuer: Hide actions and possibly reduce debt amount!
–convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company’s share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do well.

Question 8

Why would you want to induce conversions of CV’s into shares? How would you do it? How are these considerations recorded?

Answer 8

lower the amount of debt you owe to improve your debt ratio by incentivizing through cash rewards or threatening to call the bond early. These considerations are recorded as an expense

Question 9

Two ways to sweeten a bond issue and help a company issue debt when borrowing is difficult

Answer 9

Convertible bond
Detachable Stock Purchase–gives the investor an option to purchase a stated number of ordinary shares at a specified option price.

Question 10

Calculating effective interest on non interest bearing material

Answer 10

1. Divide face by present value
2. take 1/# of years (bc effective interest is annual
3. take #1^#2 - 1.

Question 11

retiring debt early leads to:

Answer 11

gains and losses

Question 12

What is the loss in the early distiguishement?

Answer 12

call price-carrying value

Question 13

how much do you pay when you retire the debt early?

Answer 13

call price