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Long-Term Debt and Other Financing Issues

Long-Term Debt and Other Financing Issues. Chapter 22. Loan Payments and Interest. Periodic loan payments consist of two components: Interest expense A portion of the principal balance. Calculating Loan Payments. Periodic Payment =. Amount Borrowed .

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Long-Term Debt and Other Financing Issues

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  1. Long-Term Debt and Other Financing Issues Chapter 22

  2. Loan Payments and Interest Periodic loan payments consist of two components: • Interest expense • A portion of the principal balance

  3. Calculating Loan Payments Periodic Payment = Amount Borrowed  Present Value of Annuity Factor Based on the Interest Rate and the Life of the Loan

  4. Calculating Interest Expense Interest Expense = Book Value of Loan at the Beginning of the Period Periodic Interest Rate X

  5. Calculating Repayment of Principal Repayment of Principal = Cash payment - Interest expense

  6. Bond Characteristics • Face Value • Maturity date • Contract rate • Bond certificate

  7. Reasons for Issuing Bonds The main reason for issuing bonds is that the earnings available to the common stockholders can be increased through leverage. Leverage is the use of borrowing to increase the return to common stockholders. It is also call trading on equity.

  8. Use of Leverage Through Bond Financing Exhibit 22-2 Before Expansion Bond Financing Stock Financing Earnings before interest and income taxes $100,000 $150,000 $150,000 Interest expense ---- (30,000) ----__ Income before income taxes $100,000 $120,000 $150,000 Income tax expense (40,000) (48,000) (60,000) Net Income $ 60,000$ 72,000$ 90,000 Number of shares 10,000 10,000 16,000 Earnings per share $6.00 $7.20 $5.63

  9. Recording Bonds Issued at Face Value Cash Bonds Payable 200,000 200,000

  10. Interest Expense Face Value of Bonds X (Annual Contract Rate  Number of Interest Payments per Year) Example: $200,000 X (10%  2) = $10,000

  11. Recording Interest Expense Cash Interest Expense 10,000 10,000

  12. Accrual of Interest Semiannual Interest X Fraction of Period since Interest Last Paid Example: $300,000 X (12%  2) X 4/6 = $12,000

  13. Recording Interest Expense Interest Payable Interest Expense 12,000 12,000

  14. Factors Affecting Bond Interest Rates • The risk-free rate • The expected inflation rate • The risk premium

  15. Bonds Issued at Less Than or More Than Face Value • Premium - bonds sold when market rate of interest is lower than the contract rate • Discount - bonds sold when market rate of interest is higher than the contract rate • Yield - the market rate at which the bonds are issued

  16. Bonds Issued at Less Than or More Than Face Value The issuance of bonds sold at a discount or premium is usually quoted as a percentage of the face value. Face Value X Quoted Percentage = Selling Price $200,000 X 97% = $194,000 $200,000 X 102% = $204,000

  17. Bond Interest Expense Interest Expense for Period = Book Value at Beginning of Period X Yield

  18. Relationship Between Bond Selling Prices and Interest Expense Exhibit 22-3 Annual Interest Expense Compared to Annual Interest Payment Yield Compared to Contract Rate Bonds Sell at Yield > Contract Rate Discount Interest Expense > Interest Paid Yield = Contract Rate Face Value Interest Expense = Interest Paid Yield < Contract Rate Premium Interest Expense < Interest Paid

  19. Zero-Coupon Bonds • Bonds pay no interest each period • Amount borrowed is less than face value • Face value is paid on the maturity date • Selling price is the present value of the face value using the annual yield • Effective interest method is used for computing yearly interest expense

  20. Effective Interest Method Selling Price of Bond Issue = Face Value X Present Value Factor Example: $1,000,000 X 0.3855 (PV of $1 factor for 10 periods at 10%) = $385,500

  21. Interest Expense for Zero-Coupon Bonds Interest Expense = Book value at beginning of period X Annual yield Example: $385,500 X 10% = $38,550

  22. Recording Interest Expense Bonds Payable Interest Expense Bal. 385,500 38,550 38,550 Bal. 424,050

  23. Recording Retirement of Bonds Cash Bonds Payable Bal. 198,000 198,000 205,000 Bal. 0 Extraordinary Loss 7,000

  24. Evaluation of Long-Term Debt and Interest Expense • Financial flexibility • Risk • Long-term liquidity

  25. Leases • Lease - an agreement giving the right to use property, plant, or equipment without transferring legal ownership • Lessee - the company that acquires the right to use the item • Lessor - the company that gives up the use of the item

  26. Types of Leases • Capital Lease - transfers the risks and benefits of ownership from the lessor to the lessee • Operating Lease - does not transfer the risks and benefits of ownership

  27. Capital Lease The lessee records an operating asset and a long-term liability at the present value of the lease payments. Present value of lease payments = Periodic lease payment X Present value of annuity factor

  28. Recording a Capital Lease Leased Property Capital Lease Obligation 15,163 15,163

  29. Recording Depreciation on Leased Asset Leased Property Depreciation Expense Bal. 15,163 3,033 3,033 Bal. 12,130

  30. Interest Expense for Capital Leases Interest Expense = Book value of lease obligation X Interest rate Example: $15,163 X 10% = $1,516

  31. Reduction of Lease Obligation Reduction of lease obligation = Cash payment to lessor - Interest expense Example: $4,000 - $1,516 = $2,484

  32. Recording Lease Payment Cash Capital Lease Obligation Bal. 15,163 4,000 2,484 Bal. 12,679 Interest Expense 1,516

  33. Mortgage Payable A mortgage payable is a long-term liability for which the lender has a specific claim against an asset of the borrower. Accounting for a mortgage payable is similar to accounting for a lease obligation.

  34. Deferred Income Taxes • A temporary difference occurs when a corporation uses different depreciation methods between the accounting records and tax records • Deferred Tax Liability - balance sheet account showing future additional income taxes • Deferred Tax Asset - balance sheet account showing the amount by which future income taxes will be reduced

  35. Retirement Benefits • Pension plan - an agreement by a company to provide income to its employees after they retire • Defined-contribution plan - specifies the amount that the company must contribute to the plan while the employees are working • Defined-benefit plan - specifies the amount that the company must pay to its employees during retirement

  36. Conclusion A bond is a type of note in which a company agrees to pay the holder the face value at the maturity date and to pay interest periodically at a specified rate on the face value. A lease is an agreement giving a company the right to use property, plant, or equipment without transferring legal ownership of the item.

  37. Problem 22-23 Present Value = Periodic Amount of X Present Value of of annuity annuity Annuity Factor $10,000 = Periodic Amount of Annuity X 3.4651 Periodic Amount of Annuity = $2,885.92

  38. Problem 22-23 Beginning Ending Balance InterestPrincipal Balance 1999 $10,000.00 $600.00 $2,285.92 $7,714.08 2000 7,714.08 462.84 2,423.08 5,291.00 2001 5,291.00 317.46 2,568.46 2,722.54 2002 2,722.54 163.38 2,722.54 -0-

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