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Novembe 18 Class Notes - WEEK 10; Chapter 11 - COMM 2AA3.docx

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Aadil Merali Juma

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WEEK 10 COMM 2AA3 Chapter 11: Reporting and Interpreting Long-Term Liabilities November 18, 2013  Capital Structure – Long-Term Debt o Long term debt can be in the form of notes payable, bonds payable, lease obligations and mortgage payable  Advantages of Bonds o Bonds are debt, not equity, so the ownership and control of the company are not diluted o Cash payments to the debt holders are limited to the scheduled payments of interest principal  Compared to when shareholders do not get return on equity (NI/shareholders equity) – can lead to problems o Interest expense is tax deductible  Dividends come after NI on statement of changes in equity – not tax deductible o Positive financial leverage  Increase return to shareholders at the expense of your creditors; cheaper to finance with debt than equity –  Disadvantages of Bonds o Risk of bankruptcy exists because the interest and principal are legal obligations and must be paid back as scheduled or creditors will force legal action  Compare to equity financing – dividends not promised; do not declare bankruptcy o A single, large principal payment is required at the maturity date – one lump sum at payment; can result in negative cash flow at that point in time o Negative impact on cash flows exist because interest and principal must be repaid in the future  Bonds Payable – a form of interest-bearing notes payable issued by corporations, universities and government agencies o Sold in small denominations, which makes them attractive to investors – usually around $1000; can purchase many bonds, many investors can afford to buy bonds o Secured (mortgage bond) vs. unsecured (debenture bond)  Secured – backed up by collateral; money lent is backed up; reserves kept by company in case money is lost  Unsecured – lend money to low risk company, low risk company goes down, money lent is lost o Convertible vs. redeemable/retractable  Convertible – debt, lent money, don’t have ability to pay you; you can convert debt to common shares (you can become part owner of company)  Redeemable – issue 40 year bond, after sometime you have money and don’t need money from bond; give money, buy back the bonds before the end of the bonds life o Bonds payable are long-term debt (liability) for the issuing company (issued paper in return for money)  Affects long term debt:equity ratio  Terminology o Contractual interest rate (stated rate, coupon rate, nominal rate, bond rate and the face rate) – rate which determines the amount of cash interest the borrowers pays and the investor receives  Know different names (6) o Market/effective interest rate (yield) – rate investor demand for loaning funds o Contract Rate – what company is willing to give you o Difference between market interest rate and contract rate – leads to discounts and premiums o Face value/bond value – amount of principal due at maturity o Market Value or Issue Price or Selling Price – quoted as a percentage of the face value of the bond; amount paid for bond  The present value, using the market rate of 1. Bond face value to be received at maturity 2. Interest payments to be received periodically after taking into account current interest rates  How do you figure out the value of a bond?  Present value of all future cash flows  Present value of $20 million that you will get 10 years from today  Present value of interest payments that you will get 20x in 10 years  Market has to be fair; if risk is the same, there should be no gain in choosing different company  Eg/ Market paying 8%, bond paying 10%  pay more for the bond (eg/ pay $22 for $20 in 10 years)  Assuming that the investment will continue to pay the same rate o Market fluctuates, bond is stable o Eg/ Bond vs. Market - $20 million, semi-annual payments  Bond – 10 year bond; 10% 1 WEEK 10 COMM 2AA3  Market – 1 year; 1 year, rate 11%  Every 6 months, market pays 0.5% more for 20 payments  Bonds can give discount to equal the amount the market pays more  Bond issued at a discount 1. Get $20 million 10 years from now; but your payment for the bond will be less o Eg/ Bond Issue Price - $19 million; get $20 million back 10 years from today  Get Interest Payment = $20 million x 10% x 6/12  Market Interest = $19 million x 11% x 6/12  Interest Expense – what would the market have paid you  Interest Payment – what are they paying you  Bond Issue Price o Bonds may be issued at  Face value – when the market rate equals the coupon rate (par)  Below face value (discount) – when the market rate is higher than the coupon rate  Above face value (premium) – when the market rate is lower than the coupon rate o Issuing Bonds at Face
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