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Chapter 11

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Wilfrid Laurier University
James Moore

BU227Ch 11 ReportingInterpreting Noncurrent Liabilities Lecture 1718Chapter 11 CHARACTERISTICS OF LONGTERM NOTES AND BONDS PAYABLE Private placement raising longterm debt directly from financial service organizations banks insurance companies and pension fund companiesOften called a note payable written promise to pay a stated sum of money at one or more specified future datesmaturity datesIn many cases a companys need for debt capital exceeds the financial capability of any single creditor Then the company may issue publicly traded debt called bonds can be traded in established markets that provide bondholders with liquidity Loans and notes are often for terms of five years or less while mortgage terms can exceed 25 yearsLenders often protect their interests by requesting that the debt be secured In the case of a personal credit card the debt is unsecured which means that if a debtor fails to make the required payment or defaults the lender cannot repossess any specific asset of the cardholder In the case of a large personal longterm loan lenders insist on the right to repossess the automobile in the event of defaultallows the lender to sell the automobile Corporations can secure their notes and bonds payable by using revenue inventory property equipment and buildings Secured debt provides the creditor with the right to foreclose on the debt and repossess the assets or collateral should the company violate the terms of its debt contract A bond usually requires the payment of interest over its life with the repayment of principal on the maturity date The bond principal is1 the amount payable at the maturity date2 basis for computing periodic cash interest payments o The principal also is called the par value face amount and maturity valueo All bonds have a par value which is the amount that will be paid when the bond matureso For most Canadian bonds the par value is 1000 but it can be any amountA bond always specifies a stated rate of interest and the timing of periodic cash interest payments usually annually or semiannually Each interest payment principalstated interest rate The selling price of a bond does not affect the periodic cash payment of interest For example a 1000 8 percent bond always pays cash interest of 80 on an annual basis or 40 on a semiannual basisDifferent types of bonds have different characteristics different types of creditors have different types of risk and return preferences Companies design bond features that are attractive to different groups of creditorsCompanies need to build research and production facilities to develop and manufacture consumer foods One possibility is to finance the project by issuing bonds that are secured by the assets that will be in place once the project is finished Another possibility is to issue bonds secured by the amount of revenues expected from the completed project The company could also issue debentures unsecured bond depending on how much risk the debenture holders are willing to takeWhen a company issues new bonds it prepares a bond indenture contract that specifies the legal provisionsMaturity date rate of interest date of each interest payment and any conversion privileges The indenture also contains covenants to protect the creditors such as limitations on 1BU227Ch 11 ReportingInterpreting Noncurrent Liabilities Lecture 1718 new debt that the company might issue in the future limitations on the payment of dividends etc Managers prefer less restrictive covenants However creditors want use these to reduce riskThe bond issuer also prepares a prospectus a legal document given to potential bond investors The prospectus describes the company the bond and how the proceeds of the bond will be usedWhen a bond is issued the investor receives a bond certificate each bondholder receives this All of the bond certificates for a single bond issue are identical The face of each certificate shows the same provisions An independent party the trustee is appointed to represent the bondholdersto determine whether the issuing company fulfills all of the provisionsPlayers in the Bond Market Most companies work with an underwriter that either buys the entire issue of bonds and then resells them to individual creditors called a firm commitment underwriter or simply sells the bonds or notes without any obligation to purchase them called a best efforts underwriter It is not uncommon for companies to use several underwriters to sell a large bond issue Bond dealers sell bonds typically to institutional investors such as banks insurance companies and mutual and pension funds They also create a secondary market for bonds by trading them for their own account in response to supply and demand by institutional investors Almost all trades occur by telephone known as an overthecounter OTC market not through a formal bond exchangeBecause of the complexities associated with bonds several agencies exist to evaluate the probability that a bond issuer will not be able to meet the requirements specified in the indenture If it becomes apparent that there has been a change in default risk for any debt already issued each rating service will issue a public bulletin that upgradesdowngrades the credit rating with reasons for the changeBond prices change for two main reasons changes in creditworthiness of the bond issuer and changes in interest rates Creditworthiness depends on operating investing and financingInterest rates depend on the supply and demand for money The most important interest rate is the rate at which the federal government can borrow money for the long term This is the benchmark riskfree rate of return on bonds because federal government will never fail to repay on its debts The interest rates of all other debt instruments are established relative to this riskfree rate The difference between the interest rate on debt instruments and the riskfree rate is called the spread MARKET INTEREST RATE is the current rate of interest on a debt when incurred also called the YIELD or EFFECTIVE INTEREST RATEEach bond indenture specifies two types of cash payments1 Principal a single payment made when the bond matures It is also called the par or face value 2 Cash interest payments computed by multiplying the principal amount times the interest rate called the contract stated or coupon rate of interest stated in the bond contract The bond contract specifies whether these payments are made quarterly semiannually or annuallyBOND PREMIUM difference between selling price and par when the bond is sold for more than parBOND DISCOUNT difference between selling price and par when the bond is sold for less than parIf a bond pays a stated interest rate that is lower than the market rate that creditors demand they will not buy it unless its price is reduced discount must be providedOppositepremiumBonds Issued at Par 2
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