Chapter 9
Non-owner Financing
Accounting Equation: Another
Look
Debt, Leverage, and Risk


Magnitude of required debt payments
increases proportionally with the level of debt
financing, and more required debt payments
implies a higher probability of default should
a downturn in business occur.
Increasing levels of debt, then, makes the
firm look riskier to investors who,
consequently, demand a higher return on the
capital they provide to the company.
Long-Term Financing


Companies typically require long-term
liabilities in their capital structure to
support long-term asset acquisitions
and maintenance.
Bonds and notes are structured like any
other borrowing - the borrower receives
cash and agrees to pay it back along
with interest.
Bonds Payable

Terminology
 Life, Maturity date
 Face value, principal, par value, maturity value
 Interest payment
 Proceeds at issuance
 Interest rate



Coupon or stated
Market or effective
Other provisions
 Call (redemption) provision
Bond Pricing
There are two different interest rates you must understand
before we can discuss the mechanics of bond pricing:
1. Coupon (contract or stated) rate – the stated rate in the
bond contract. It is used to compute the dollar amount of
(semiannual) interest payments that are paid to
bondholders during the life of the bond issue.
2. Market (yield) rate – the interest rate that investors
expect to earn on the investment in the debt security. This
rate is used to price the bond issue (.i.e, the discount rate
in the PV calculation)
Coupon Rate vs. Market Rate
When a company issues a
bond, what is it selling?

Assume a company issues a $1,000, 5%,
10 year bond, payments are semi-annual.
What is the company selling?


Interest payments of $25 at the end of each
of 20 six month periods. (An ordinary
annuity.)
A lump-sum payment of $1,000 at the end of
10 years.
Cash Flows from Bonds
Bondholders normally expect to receive
two different cash flows:



Periodic (usually semiannual) payments of
interest during the bond life. These payments
are often in the form of equal cash flows at
periodic intervals, called an annuity.
Single payment of the face (principal)
amount of the bond at maturity.
Cash Flows from Bonds


To illustrate, assume that investors wish to price
a bond with a face amount of $10 million, an
annual coupon rate of 6% payable semiannually
(3% semiannual rate), and a maturity of 10
years.
Investors purchasing this issue will receive the
following cash flows:
Bond Pricing:
Coupon Rate = Market Rate (Par)


Company promises to pay 20 semiannual payments
of $10 million  (6%/2) = $300,000 each, plus the
$10 million face amount of the bond at maturity, for a
total of $16 million.
Assuming that investors desire a 6% annual market
rate of interest (yield), the bond sells for $10 million:
Bond Pricing:
Coupon Rate < Market Rate (Discount)


Assume that the company is not viewed as an
acceptable credit risk and, to compensate for
accepting a higher level of risk, investors expect an
8% annual yield (4% semi-annual yield).
Given this new discount rate, the bond will sell for
$8,640,999:
Bond Pricing:
Coupon Rate > Market Rate (Premium)

Assume that investors expect only a 4%
annual yield (2% semiannual yield). Given
this new discount rate, the bond sells for
$11,635,129 – see below:
Book Value

Net book value = principal plus
unamortized premium or less
unamortized discount.
Bond Interest Expense

2 components:



Cash interest payments (usually semiannual).
Amortization of bond premium or discount.
GAAP requires the effective interest rate
method of amortization.
Effective Interest Rate



Actual rate paid by issuer
May or may not be same as the stated
rate
Determined by discount rate that sets
the present value of the future cash
outflows equal to the fair market value
of that which is received in the
exchange.
Effective Interest Rate Method
Bond Disc. Amortization Table

Beginning book value.


Interest expense.


Face amount * stated interest rate.
Discount amortization.


Beginning book value * effective interest rate.
Interest paid.


Bonds payable – unamort. Disc. (or + Prem.).
Interest expense - interest paid.
Ending book value.

B. payable - new unamort. Disc. (or + Prem.).
Accounting for
Long-Term Obligations




Record the asset acquired in the exchange at
its fair market value.
Record the obligation at its face value.
Record a discount or premium if the
obligation is different than the fair market
value of the asset acquired.
Record interest expense for each period:
effective interest rate x balance sheet value
of the obligation at the beginning of the
period.
Accounting for Bonds:
Income Statement
Interest expense in the income statement is the sum of two components:



Amortization of a discount adds to the cash interest paid to compute
interest expense.
Amortization of a discount reflects additional cost the company
incurs upon sale of the bonds; and, recognition of this cost through
its amortization yields increased interest expense.
Conversely, a premium is a benefit the company receives at
issuance of a bond; and, amortization of a premium yields reduced
interest expense.
Effective Interest Method
(Discount Example)
Companies amortize the discount and premium using
the effective interest method
Effective Interest Method
(Premium Example)
Gain (Loss) on Repurchase of Bonds





Purchase of a bond is like the sale of a long-term asset
A gain or loss can result from a repurchase.
Book value of the bond is the net amount that appears
on the balance sheet.
If the company pays more to retire the bonds than they
carry on the balance sheet, this is a cost that is reflected
in the income statement as a loss on retirement of
bonds.
Conversely, a company reports a gain on retirement of
bonds if the purchase price is less than its book value.
Off-Balance Sheet
Financing



Off-balance sheet financing means
that either liabilities are kept off of the
face of the balance sheet.
In this chapter we discuss leases.
Variable interest entities (called SPEs in
the past) were previously discussed
when we covered the equity method of
accounting.
Motives for using Off-Balance
Sheet Financing




In general, companies desire to present a
balance sheet with sufficient liquidity and less
indebtedness.
The reasons for this are as follows: liquidity
and the level of indebtedness are viewed as
two measures of solvency.
Companies that are more liquid and less
highly financially leveraged are generally
viewed as less likely to go bankrupt.
As a result, the risk of default on their bonds
is less, resulting in a higher rating on the
bonds and a lower interest rate.
Leasing


A lease is a contact between the owner of
an asset (the lessor) and the party desiring
to use that asset (the lessee).
Generally, leases provide for the following
terms:
1.
2.
3.
The lessor allows the lessee the unrestricted
right to use the asset during the lease term
The lessee agrees to make periodic payments to
the lessor and to maintain the asset
Title to the asset remains with the lessor, who
usually retakes possession of the asset at the
conclusion of the lease.
Advantages to Leasing
1.
2.
3.
Leases often require much less equity
investment than bank financing.
Since leases are contracts between
two willing parties, their terms can be
structured in any way to meet their
respective needs.
If properly structured, neither the
leased asset not the lease liability are
reported on the face of the balance
sheet.
Operating Lease

Operating lease method. Under
this method, neither the lease asset
nor the lease liability is on the
balance sheet. Lease payments are
recorded as rent expense when
paid.
Operating Leases
1.
2.
3.
Leased asset is not reported on the balance
sheet.
Lease liability is not reported on the balance
sheet.
For the early years of the lease term, rent
expense reported for an operating lease is less
than the depreciation and interest expense
reported for a capital lease.
Capital vs. Operating Leases

Capital lease method. This method
requires that both the lease asset and the
lease liability be reported on the balance
sheet. The leased asset is depreciated like
any other long-term asset. The lease
liability is amortized like a note, where
lease payments are separated into interest
expense and principal repayment.
Capital vs. Operating Leases



The benefits of applying the operating method
for leases are obvious to managers.
The lease accounting standard, unfortunately, is
structured around rigid requirements. Whenever
the outcome is rigidly defined, clever managers
that are so-inclined can structure lease contracts
to meet the letter of the standard to achieve a
desired accounting result when the essence of
the transaction would suggest a different result.
This is form over substance.
Capital Leases

Capital leases




Effectively an installment purchase
Lessee assumes rights and risks of ownership
Treated as purchases
Examples of what constitutes a capital
lease



PV of lease payments is the FMV of the asset
Period of the lease approximates the assets
life
There is a bargain purchase price
Footnote Disclosures of Lessees
Capitalizing Operating Leases for
Analysis Purposes
1.
2.
3.
Determine the discount rate to compute the present
value of the operating lease payments.
This can be inferred from the capital lease
disclosures, or one can use the company’s debt
rating and recent borrowing rate for intermediate
term secured obligations as disclosed in its longterm debt footnote.
Compute the present value of the operating lease
payments.
Add the present value computed in step 2 to both
assets and liabilities.
Capitalization of Midwest Air
Operating Leases