Chapter 9 Debt Financing: Bonds, Notes and Leases

Question 1

Debt Financing

Answer 1

Most Companies finance at least a part of their operations with debt. One of the reasons for this is that debt financing is almost always a less expensive form of financing than equity.

-Because they expected return by creditors is less than the expected return by investors due to equity investments being more risky

Question 2

Creditors vs Shareholders

Answer 2

Shareholders are likely to lose all of their invested capital if a company fails, whereas creditors are likely to lose only part, if any, because they have first claim on any remaining assets of the company.

Question 3

Loan Duration

Answer 3

Desired length of the borrowing period

Question 4

Bonds

Answer 4

Publicly issued financial instruments that promise to pay the bondholder periodic payments overt he life of the investment, usually 10 to 20 years, and then make a lump-sum principal repayment at maturity

Question 5

Notes

Answer 5

Are similar instruments but have shorter maturities, usually one to ten years and are frequently privately placed with large institutional investors or financial institutions

Question 6

Bonds and Notes:

Common Features

Answer 6

1) No voting rights at the annual shareholders meeting
2) An indenture agreement that specifics covenants, often based on accounting ratios, which may restricts the borrowers ability to pay dividends, issue additional debt, undertake mergers and acquisitions, or sell asses
3) A trustee, which administers the provisions of the indenture agreement and acts as an independent party to protect the interests of the lenders
4) Priority in receiving interest and principal repayments over any payments to common and preferred shareholders such as dividends or payments in liquidation

Question 7

Secured

Answer 7

Bonds and Notes may be secured, that is, the lender had a priority claim on specific assets of the borrower in the event of default

Question 8

Unsecured

Answer 8

having no claim on specific assets in the event of a default

Question 9

Unsubordinated

Unsecured

Answer 9

Will always be paid before any other forms of debt

Question 10

Convertible

A debt holder option

Answer 10

Bonds and Notes can be converted into common shares of the borrower.

Question 11

Cost of Debt

Answer 11

The interest on debt that is earned by the lender and paid by the company

Question 12

Credit Risk Rating

Answer 12

A score that indicates the likelihood that the borrower will make all interest and principal payments on a timely basis

Question 13

Junk Bonds

Answer 13

Also known as high-yield bonds, have a significantly higher probability of default, and thus carry higher rates of interest.

Question 14

Credit Rating Agencies

Answer 14

Perform a valuable service to the debt investor community by serving as independent analysts of a company’s credit worthiness

Question 15

Liabilities

Answer 15

Generally valued at their present value

Question 16

Present Value

Answer 16

A dollar today is worth more than that same dollar in the future.

• A dollar invested today can earn a positive return over time
• Inflation can erode the purchasing power of a future dollar

Question 17

Maturity Value

Answer 17

The value after interest

Question 18

Coupon Rate

Answer 18

the cash rate of interest on a debt instrument. It is used only to determine the periodic cash flow paid as interest to the bondholder or noteholder

Question 19

Yield Rate

Answer 19

The effective or market rate of interest. Used to discount both the periodic cash interest payments and the lump-sum repayment of principal at maturity

Also known as the effective rate or market rate of interest

Question 20

Early Debt Retirement

Answer 20

Companies sometimes find that they no longer need their existing debt financing. When this situation arises, companies will sometimes re-purchase, or retire their outstanding interest-bearing debt.

How debt is retired

1) Cash Payment is made to investors
2) Note/Bonds Payable removed from accounting records
3) Note discount/premium is removed from accounting records
4) Difference is a gain/loss on early retirement

Question 21

Zero-Coupon Bonds and Notes

Answer 21

Have no coupon rate, thus , pay no periodic cash interest payment. Instead, the regular but unpaid interest is added to the principal value of the bond (or note) and is paid as a lump sum at maturity. Not annuity payment.
-Riskier to investors because they need to wait longer for cash returns. This conserves cash because its a single payment at the end.

Question 22

Accreted Value

Answer 22

The original issue price plus any accrued, but unpaid, interest.

Question 23

Leaseing

Answer 23

Is a vehicle for financing the short or long term use of an operating asset

Question 24

Finance Lease

Answer 24

If the lessee can answer yes to any of the below, then the lease is classifiable as a finance lease
-Ownership transfer
-Purchase option
Lease term
-Present value of lease payments
Alternative use

Question 25

Amortization Schedule

Answer 25

The interest expense each period is the beginning liability balance multiplied by the interest rate and then the liability is decreased by the portion of the least payment allocable as a principle reduction.

Question 26

Estimated Yield to Maturity Formula

Answer 26

( (Annual Interest Payment) + ( (Face Value - Current Price) / (Years to Maturity) ) )

/

( ( Face Value + Current Price ) / 2 )

Question 27

How do you compute the selling price of a bond?

Answer 27

The selling price or the market value of a bond is the present value of the future cash derived from the bond. In other words, the semiannual interest payments and the payment of the face value of the bond at its maturity date will be discounted by the market interest rate. The resulting present value of those two amounts is the market value.

Question 28

Does yield equal interest rate?

Answer 28

Yield is also the annual profit that an investor receives for an investment. The interest rate is the percentage charged by a lender for a loan. Interest rate is also used to describe the amount of regular return an investor can expect from a debt instrument such as a bond or certificate of deposit (CD)

Question 29

Yield Rate

Answer 29

is the market rate of interest on a bond, all right? So it’s what’s getting paid in the market. So every day, interest rates fluctuate and change. That’s what we’re talking about.

Question 30

Stated Rate

Answer 30

any time that you buy a bond– and it’s rare that people actually see a physical bond anymore, but it actually has printed on it a rate. So it’s stated on the face of the bond. So it’s also sometimes called a coupon rate, a nominal rate, because it doesn’t move with the markets. There’s a few synonymous terms

Question 31

face value of the bond

Answer 31

printed on the face of the bond is a number. And that’s how much the bond is worth.

Question 32

Factors affecting source of debt financing

Answer 32

1) Loan Duration
2) Amount of the borrowing
3) Riskiness of the borrower

Small firms are considered more risky than large firms

Question 33

Subordinated

Unsecured

Answer 33

Lower priority, junior claim, below secured creditors

Question 34

Callable

A borrower option

Answer 34

Can be redeemed or retired prior to maturity

Question 35

Cash Flow Streams

What does the bond or note investor get?

Answer 35

2 Cash Flow Streams

1) A lump sum payment at maturity for the principle loaned to the borrow
2)Periodic interest payments based on the coupon rate
(Quarterly or semi-annually)

Question 36

What is a discount

Answer 36

Additional income demanded by investors to earn an effective rate of return equal tot he market rate of interest

Investors are unwilling to buy notes and bonds that pay interest less than the prevailing market rate for notes and bonds similar risk unless they can buy it at a discount

Question 37

What is a premium

Answer 37

Reduction of income so that investors earn an effective rate of return equal to the rate they demand, or the market rate of interest

• By doing so, they are effectively earning the market rate of interest

Question 38

Interest Ammoritization

Answer 38

The process of allocating a bond or note discount or premium over the various interest compounding periods

Two methods:
- Straight line method - Taking the bond and discount and dividing it by the number of periods
-Effective interest rate method - The interest is a function of the book value of notes and bonds (Understand the interest amortization table)
Interest Expense(t) = Book Value (t-1) x Effective yield rate

Question 39

Types of Leases

Answer 39

1) Operating Lease - Any lease not classified as a finance lease.
2) Finance Lease - A defacto asset purchase agreement involving a deferred payment plan

Question 40

Finance Lease Criteria

Answer 40

1) Ownership transfer - At the end of the lease, does ownership transfer?
2) Purchase option - Does the lease agreement contain a purchase option that is reasonably expected to be exercised
3) Lease Term - Is the lease term a major part of the economic life of the asset
4) Present value of lease payments - Is the present value of future payments substantially all the value of the asset
5) Alternative use - will the asset have no alternative use to the lessor at the end of the lease term

Question 41

Weighted Average Cost of Debt

Answer 41

Calculated by averaging a firms various interest rates, weight by the amount of debt outstanding at the various rates

Question 42

Problem 9.1

Answer 42

Bonds = Publicly issued financial instruments
Notes = Typically privately placed financial instruments with shorter maturities
Trustee = The person or entity that administers the provisions of the indenture agreement
Secured = The lender has a priority claim on specific asset of the borrower in the event of a default
Debenture = The lender has no claim on specific assets in the event of a default
Subordinated = a lower priority claim
Convertible = Bonds or notes that carry a share conversion ratio
Callable = A bond or note that can be mandatorily redeemed prior to maturity

Question 43

Amortized

Answer 43

Difference between interest payments and expense

Question 44

Long Term Debt to Total Asset Ratio

Answer 44

Long Term Debt / Total Assets

Question 45

Long term debt to share holder equity ratio

Answer 45

Long term debt / SE

Question 46

Interest Coverage Ratio

Answer 46

(Net Income before taxes + Interest expense) / Interest Expense

-Are we generating enough income to cover our interest expense

Question 47

Balance Sheet Value

Answer 47

Balance sheet value at end of the first year = Outstanding balance at beginning of second six month + second six month interest expense - cash payment of coupon interest