Long Term Debt (Financial Liabilities)

Question 1

When to record gain on Debt restructuring agreement for borrower.

Answer 1

First test if the total amount of cash to be paid when loan is due (principal plus future interest of new debt agreement) is less the current book value of debt (current principal plus accrued interest).
*if new agreement total is GREATER than old, then NO gain is recog’d.
*if new agreement total is LESS than old, then need to calculate gain.

2. If less then calc gain:
   Ex. Borrows $800K on Jan 1, Yr 1 on 5 yr note @10% int due on Dec 31 each year. They don’t make int pmt in yr 1, so bank restructures agreemnt to new princ of $500,000 @ 6% due in 9 yrs. Present val of future cash at 10% effective rate is $380K.
   1. Find current amount of total debt: Current princ + accrued int at current rate $800k + (800k10%=80k) = $880k
   2. Calc future cash flows: New princ + (new intnew #of yrs)
   $500k + ((500k6%)9=270k) = $770k
   3. Compute diff between two total cash flows:
   $880k - $770K = $110k of gain to be recog’d
   (For this example, the PV of future CF at 10% effective rate is ignored, this is used for the bank side of calc.)

If gain is recorded, then borrower writesdown book val of debt to the sum of the undiscounted future cash flows ($770k in ex above) and then all future payments will be a reduction of the liability and no interest exp will be recog’d.

Question 2

How to record liability on No interest baring notes

Answer 2

The cash flows must be recorded at the present value using a reasonable interest rate.

So take the principal payment times the PV of a $1, and the total interest payments for the life of the loan times the PV of an ordinary annuity. Add those amounts to get your original face value of note recording. Then depending on interest to be paid, the excess interest of cash paid vs total interest expense is compounded and added to principal.

Question 3

How to record loss on debt restructure for bank.

Answer 3

Bank has to writedown its receivable to the present value of all future cash flows. Use the PV of future cash flows with the original interest rate of the loan. Ignore the new interest rate, even for the interest revenue received on new loan balance, use old interest rate.

(Even if borrower doesn’t have to report gain (if future CF’s are greater than total present debt), the bank still has to report a loss.)

Question 4

Comparing Interest expense of discount bond using straightline method vs effective method.

Answer 4

The discount (diff between face value and selling price of bond) is and to stated interest expense evenly over life of bond.
Ex. $100k bond @5% for 4yrs, sold at $90k to yield 8% effective rate. Compare straightline to effective rate method at yr 2.

Straightline method:
$100k-90k= $10k discount / 4yrs = $2,500
Stated int exp = $100k x 5% = $5k cash + $2.5k discount = $7.5k total int exp.

Effective rate method:
Yr 1: $100k x 5% = $5k cash int
$90k x 8% = $7.2 total int exp
$7.2 - 5k = $2.2k added to principal
Ending principal bal = $90k + 2.2k = $92.2k

Yr 2: $100k x 5%= $5k cash int
$92.2k x 8% = $7,376 total int exp
$7,376 - 5k = $2,376 added to princ
Ending principal bal = $94,576

$7,500 - $7,376 = $124 higher under straightline method.

Question 5

Find bond sales price.

Answer 5

The bond sales price is the present value of expected net cash flows discounted for market interest rate.

Ex. Company offers to sell $100k 10yr bond @ 2%, but buyer wants 5% interest (market rate).
PV info as follows (provided in question):
-PV of single amount $1 in 10yrs @ 2% is .80
-PV of single amount $1 in 10yrs @ 5% is .63
-PV of annuity $1 in 10yrs @ 2% is 8.75
-PV of annuity $1 in 10yrs @ 5% is 7.70

1. First find interest cash flow of the face val of bond offered by company.
   $100k x 2% = $2k interest per yr
   Then you take that amount times the PV of annuity at market rate which is 5% in ex.
   $2k x 7.70 = 15,400
2. Find cash flow of principal of bond at market rate.
   $100k x .63 = $63k
3. Add them together to get total sales price.
   $15,400 + $63k = $78,400 sales price

Question 6

Record bond value when stock warrants are also issued .

Answer 6

In this case 2 things are issued for a single price, ie. bond and warrants. If both values are known then you prorate them based on relative vals. If only one is known then use that value for reporting purposes and the remainder is given to other item.

Ex. Company issues 1,000 bonds w/ face val of $1,000 each. Each bond is sold w/ 4 stock warrants, which allows owner to buy a share of company’s stock for $9 at any time in next 24 months. The common stock was selling @ $10 per share on that date. The options are traded in the market @ $6 each. What is initial reported val of these bonds if cash received by company was $990k?

In ex only the value of the warrants is given, which is that options are traded in market @ $6. There are 4k warrants issued at time of sale (1k bonds x 4 warrants each), so their value is 4k x $6 = $24k, and that’s recorded under stockholder equity.

Then to find value of bonds, take total cash received minus the warrants value. $990k - $24k = $966k