ANALYSIS OF FINANCING LIABILITIES

FOCUS

• Understand the FS effects of issuing a bond at par, at a discount, or at a premium.

• Calculate the book value of the bond and interest expense at any point of time using the effective interest rate method.

• Calculate the gain or loss from retiring a bond before its maturity date

FINANCING LIABILITIES

• A bond is a contractual promise between a borrower and a lender that obligates the bond issuer to make payments to the bondholder over the term of the bond.

• Two types: periodic interest payments, repayment of principal at maturity.

• The face value: maturity value/ par value: the amount of principal that will be paid to the bondholder at maturity used to calculate the coupon payments.

• The coupon rate: the interest rate stated in the bond used to calculate the coupon payments.

• The coupon payments: the periodic interest payments to the bondholders.

• The effective rate of interest: interest rate that equates the present value of the future CF of the bond and the issue price.

• The balance sheet liability: equal to the present value of its remaining CF, discounted at the market rate of interest at issuance.

• The interest expense: is calculated by multiplying the book value of the bond liability at the beginning of the period by the market rate of interest of the bond when it was issued.

• The market rate = coupon rate par bond (priced at face value)

• Market rate > coupon rate discount bond (priced below par)

• Market rate < coupon rate premium bond (priced above par)

EXAMPLE: BOOK VALUES AND CF

• On Dec 31, 20X2, a company issued a 3 year, 10% annual coupon bond with a face value of $100,000. Calculate the book value of the bond at year – end 20X2, 20X3, 20X4 and the interest expense for 20X3, 20X4 and 20X5, assuming the bond was issue at a market rate of interest of 10%, 9% and 11%

FS EFFECTS OF ISSUING A BOND• Cash flow impact of issuing a bond

Cash flow from financing

Cash flow from operations

Issuance of debt Increased by cash received

No effect

Periodic interest payments

No effect Decreased by interest paid

Payment at maturity

Decreased by face value

No effect

• Income statement impact of issuing a bondInterest expense = market rate at issue x balance sheet value of liability

at beginning of periodIssued at par Issued at premium Issued at a discount

Market rate = coupon rate

Market rate < coupon rate

Market rate > coupon rate

Interest expense = coupon rate x face value = cash paid

Interest expense = cash paid – amortization of premium

Interest expense = cash paid + amortization of discount

Interest expense is constant

Interest expense decreases over time

Interest expense increases over time

• Balance sheet impact of issuing a bond

Issued at par Issued at a premium Issued at a discount

Carried at face value

Carried at face value plus premium

Carried at face value less discount

The liability decreases as the premium is amortized to interest expense

The liability increases as the discount is amortized to interest expense

THE ROLE OF DEBT COVENANTS IN PROTECTING CREDITORS

• Debt covenant: restrictions imposed by the lender on the borrower to protect the lender’s position.

• Can reduce default risk and reduce borrowing costs.

• The restrictions can be in the form of affirmative covenants or negative covenants.

AFFIRMATIVE COVENANTS

• Make timely payments of principal and interest

• Maintain certain ratios in accordance with specified levels.

• Maintain collateral

NEGATIVE COVENANTS

• Increasing dividends or repurchasing shares.• Issuing more debt.• Engaging in mergers and acquisitions.

DISCLOSURES RELATING TO DEBT• Balance sheet• Footnote disclosure

The nature of the liabilitiesMaturity datesStated and effective interest ratesCall provisions and conversion privilegesRestrictions imposed by creditorsAssets pledged as securityThe amount of debt maturing in each of the next five

years

MOTIVATIONS FOR LEASING INSTEAD OF PURCHASING THEM

• Finance lease:

a purchase of an asset that is financed with debt.

The lease will add equal amounts to both assets

and liabilities on the balance sheet,.

the lease will recognize depreciation expense on

the asset and interest expense on the liability.

• Operating lease:

Is essentially a rental arrangement

Not asset or liability is reported by the lessee

The periodic lease payments are simply recognized

as rental expense in the income statement.

CERTAIN BENEFIT FROM LEASING

• Less costly financing• Reduced risk of obsolescence• Less restrictive provisions• Off balance sheet financing• Tax reporting advantages

DISTINGUISH FINANCE LEASE AND OPERATING LEASE

• LESSEE’S PERSPECTIVE: require a lease to be treated as a finance lease, include:

- Title to the leased asset is transferred to the lessee at the end of the lease.

- The lease term covers a major portion of the asset’s economic life (75% or more)

- The present value of the lease payment is 90% or more of the fair value of the leased asset

• LESSOR’S PERSPECTIVE:- Finance lease: all rights and risks of ownership

are transferred to the lease- Operating lease: the lessor recognizes rental

income and continues to report and depreciate the leased asset on its balance sheet.

DETERMINE THE INITIAL RECOGINITION AND MEASURMENT • REPORTING BY THE LEASE:- Operating lease:

the balance sheet is unaffected. No asset or liability is reported by the lessee. During the term of the lease, rent expense equal

to the lease payment is recognized in the lessee’s income statement.

In the CFS, the lease payment is reported as an outflow from operating activities

• Finance lease:

The lower of the present value of future minimum lease

payments or the fair value of the leased asset is recognized

as both an asset and liability on the lessee’s balance sheet.

The asset is depreciated in the income statement and

interest expense is recognized.

Interest expense is equal to the lease liability at the

beginning of the period multiplied by the lease interest

rate

FS AND RATIO EFFECTS OF OPERATING AND FINANCE LEASES

• Balance sheet:- A finance lease results in a reported asset and a liability.- Turnover ratios that use total or fixed assets in their

denominators will be lower when a lease is treated as a finance lease.

- ROA will also be lower for finance leases.- Leverages ratio, debt to assets ratio, debt to equity will

be higher with finance leases then operating leases.

• Income statement:

EBIT will be higher for companies that use finance

leases relative to companies that use operating

leases.

Operating lease: entire lease payment is an

operating expense

Finance lease: only depreciation of the leased asset

is treated as an operating expense.

• Cash flow statement:- Total cash flow is unaffected by the

accounting treatment of a lease.- If the lease is treated as an operating lease

the total cash payment reduces cash flow from operations.

- If the lease is treated as a finance lease the portion of the lease payment that is considered interest expense reduces CF from operations.

FINANCE LEASE OPERATING LEASE

Assets Higher Lower

Liabilities (current and long term)

Higher Lower

Net income (in the early years)

Lower Higher

Net income (later years)

Higher Lower

Total net income Same Same

EBIT (operating income)

Higher Lower

CF from operations Higher Lower

CF from financing Lower Higher

Total cash flow Same Same

FINANCE LEASE OPERATING LEASE

Current ratio Lower Higher

Working capital Lower Higher

Asset turnover Lower Higher

Return on assets Lower Higher

Return on equity Lower Higher

Debt/ Assets Higher Lower

Debt/ Equity Higher Lower