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8. Sources of Capital: Debt. Liability. Definition : Obligation to an outside party Arises from a transaction or an event that has already happened Estimated warranty is an example of a liability that is not a definite obligation:
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8 Sources of Capital:Debt
Liability • Definition: • Obligation to an outside party • Arises from a transaction or an event that has already happened • Estimated warranty is an example of a liability that is not a definite obligation: • dr. Estimated warranty expenses, cr. Allowances for warranties
Contingency • Uncertainty as to possible gain or loss that will ultimately be resolved by some future event: • Gain contingencies usually not reported (conservatism)
Loss Contingency • Potential future payment from existing conditions • Uncertainty about amount • Outcome will be resolved by future events
Levels of likelihood/GAAP • Probable: • Reasonably estimated/Accrue • Not reasonably estimated/Disclose • Reasonably possible/Disclose • Remote/No accrual (no disclosure)
Contingent liabilities on FS? • Expect to be sued due to damage caused by our product, outcome unknown • Pending lawsuit, probable loss from $100K to $2K (reasonably possible?) • Lawsuit pending, remote chance of loss • Sales during year were $1K, products warranted for 1 year; historically: • Warranty costs are 3% of sales • Bad debts are 2% of sales
Sources of funds • Debt capital: • Company pays for use of capital that others furnish • Equity capital: • Obtained from shareholders: • Direct contribution (paid-in capital) • Indirect contribution (retained earnings)
Debt Capital • Debt instruments: • Term loans: • Repayable according to a specified schedule usually with equal installments of principal and interest • U.S.: less important source of debt capital compared to bonds • Bond: • Certificate promising to pay its holder: • Specified sum of money at a stated date and • Interest at a stated rate until maturity
Bonds • Interest rate usually constant through life, could be variable (variable-rate bonds) • Payment of principal at maturity of bonds: • Cancellation under some circumstances earlier than maturity
Accounting for Bonds • Issuance at par - no issuance costs • Cash 100 • Bonds payable 100
Issuance at par - with issuance costs Cash 100 Deferred charges - bond issuance costs 5 Bonds payable 105
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? And what are investors buying? • 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
Leased Assets • Operating leases: • Rent or leases in which payments are expensed • Capital or financial leases: • Lessee effectively purchases asset: • Use of asset for its economic life is a purchase • Lease is effectively an installment purchase or a financing tool • Treated as a purchase of an asset and creation of a liability
Analysis of capital structure • Invested capital = permanent capital = debt capital + equity capital • Leverage = measure of soundness of company’s financial position: • Debt equity ratio = (total liabilities or non-current liabilities or debt) Shareholders’ equity • Debt capitalization ratio = Debt / (Debt + shareholders’ equity) • Times interest earned = interest coverage ratio = Pre-tax income before interest expense / interest expense
Discussion Questions • What has more risk: debt or equity capital? • From company point of view? • From investor point of view? • Why do we use the term leverage for the debt-to-equity ratio?
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