Chapter 9 Debt Financing: Bonds, Notes and Leases Flashcards
Debt Financing
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
Creditors vs Shareholders
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.
Loan Duration
Desired length of the borrowing period
Bonds
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
Notes
Are similar instruments but have shorter maturities, usually one to ten years and are frequently privately placed with large institutional investors or financial institutions
Bonds and Notes:
Common Features
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
Secured
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
Unsecured
having no claim on specific assets in the event of a default
Unsubordinated
Unsecured
Will always be paid before any other forms of debt
Convertible
A debt holder option
Bonds and Notes can be converted into common shares of the borrower.
Cost of Debt
The interest on debt that is earned by the lender and paid by the company
Credit Risk Rating
A score that indicates the likelihood that the borrower will make all interest and principal payments on a timely basis
Junk Bonds
Also known as high-yield bonds, have a significantly higher probability of default, and thus carry higher rates of interest.
Credit Rating Agencies
Perform a valuable service to the debt investor community by serving as independent analysts of a company’s credit worthiness
Liabilities
Generally valued at their present value
Present Value
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
Maturity Value
The value after interest
Coupon Rate
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
Yield Rate
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
Early Debt Retirement
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
Zero-Coupon Bonds and Notes
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.
Accreted Value
The original issue price plus any accrued, but unpaid, interest.
Leaseing
Is a vehicle for financing the short or long term use of an operating asset
Finance Lease
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
Amortization Schedule
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.
Estimated Yield to Maturity Formula
( (Annual Interest Payment) + ( (Face Value - Current Price) / (Years to Maturity) ) )
/
( ( Face Value + Current Price ) / 2 )
How do you compute the selling price of a bond?
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.
Does yield equal interest rate?
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)
Yield Rate
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.
Stated Rate
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
face value of the bond
printed on the face of the bond is a number. And that’s how much the bond is worth.
Factors affecting source of debt financing
1) Loan Duration
2) Amount of the borrowing
3) Riskiness of the borrower
Small firms are considered more risky than large firms
Subordinated
Unsecured
Lower priority, junior claim, below secured creditors
Callable
A borrower option
Can be redeemed or retired prior to maturity
Cash Flow Streams
What does the bond or note investor get?
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)
What is a discount
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
What is a premium
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
Interest Ammoritization
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
Types of Leases
1) Operating Lease - Any lease not classified as a finance lease.
2) Finance Lease - A defacto asset purchase agreement involving a deferred payment plan
Finance Lease Criteria
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
Weighted Average Cost of Debt
Calculated by averaging a firms various interest rates, weight by the amount of debt outstanding at the various rates
Problem 9.1
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
Amortized
Difference between interest payments and expense
Long Term Debt to Total Asset Ratio
Long Term Debt / Total Assets
Long term debt to share holder equity ratio
Long term debt / SE
Interest Coverage Ratio
(Net Income before taxes + Interest expense) / Interest Expense
-Are we generating enough income to cover our interest expense
Balance Sheet Value
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
