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Chapter 14

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Wilfrid Laurier University
Allan Foerster

Chapter 14 Long-Term Financial Liabilities Long-term debt - Obligations which are not payable within one year o Or one business operating cycle, what ever is longer - Often has restrictive covenants attached o These are terms and conditions Bonds - A bond indenture is a promise to pay a sum of money at the designated date and periodic interest at the stipulated rate on the face value o Interest is usually paid semi annually o Face value is usually $1,000 - Bond issue may be sold through o An investment banker (who acts as a selling agent on the market) or  Can do two things  Firm Underwriting o Underwrite the entire issue by guaranteeing a certain sum to the corporation (who initially wanted to sell the bonds)  Takes on the risk of selling the bonds for whatever price the agent can get  Best efforts underwriting o May sell the bond issue for a commission that will be deducted from the proceeds of the sale o By private placement  When a company sells a bond directly to large institution with out the aid of an underwriter Notes payable - Requires repayment of principle at a future date and period it interest payments - Different from bonds because they don’t normally trade on public markets - Notes and bonds are recorded at the PV of future interest and principle o Any premiums/discounts on the purchase of the bond/note payable is amortized over the life of the note Types of bonds/notes - Bearer (coupon) Bonds o Not recorded in the owners name and may be transferred from one owner to another by just delivering it to the new owner - Registered bonds o Bonds issued in the owners name o To sell a registered bond, the current certificate has to be surrendered and a new certificate is than issued - Secured debt o Debt that is back by a pledge of some sort of collateral  Collateral trust bonds or notes are secured by shares and bonds of other corporations - Unsecured debt o Debt that is not backed by collateral  Junk bonds are unsecured and also very risky  Therefore pay higher interest rates - Term bonds o Debt issues that mature on a single date - Serial bonds o Debt issues that mature in installments - Perpetual bonds o Have unusually long terms - Income bonds o Bonds that pay no interest unless the issuing company is profitable - Revenue bonds o Interest is paid from a specified revenue source - Deep discount bonds o Have little or no interest and are therefore sold at a large discount  Which provides the buyer with a “total interest payoff” at maturity - Callable bonds o Give the issuer the right to call and retire the debt before maturity o Sometimes known as demand loans - Convertible debt o Allows the holder or the issuer to convert the debt into other securities such as common shares Bond ratings - Independent credit rating agencies assign a credit rating to each new public bond issue - The rating reflects a current assessment of the company’s ability to pay the amounts that will be due on the specific borrowing - The ratings range from a quality of prime to very speculative o AAA rating means Prime (not very speculative) o B is very speculative - Investment grade securities are high quality securities (not very speculative) and only certain securities quality o Due to the fact that an investment grade rating on a specific debt offering allows greater access to capital  There is pressure on a company to ensure that its debt instruments are rated investment grade Valuing Bonds - Bond prices are derived through the supply and demand of buyers and sellers - The investment community (or the buyers and sellers) value a bond at the PV of the future cash flows (this is the price of a bond) o The PV of the interest payment annuity + the PV of the redemption value  Discounted using the market (yield) rate of interest in effect at the issue date - When bonds or notes are issued on an interest payment date at par (face value) o No interest has been accrued for and there is no premium or discount - When the market rate > coupon rate o The bond sells at a discount  When bonds sell at a discount it means investors are demanding a rate of interest that is higher than the stated rate  Because they are unhappy with the stated rate, they refuse to pay face value for the bond  This effectively allows them to achieve the effective rate of interest that they want by lowering the amount willing to pay for the bond - When the market rate < coupon rate o Sells at a premium  When bonds sell at a premium it is because the sellers are demanding a rate of interest that is lower than the stated rate  Because they can’t change the rate, they refuse to sell at face value, and demand more money  This drives the selling price up, which effectively changes the effective rate of interest - Amortizing the discount/premium o Premium decreases the annual interest expense for the corporation o Discounts increases the annual interest expense for the issuing corporation o Method 1: Straight Line (ASPE)  Allocates the same amount of discount (or premium) to each interest period  Find the annual discount/premium by dividing the amount of discount/premium by the bond maturity  To record the annual discount  DR Interest expense  CR Bonds Payable  To record the annual premium  DR Bonds Payable  CR Interest Expense o Method 2: Effective Interest (IFRS and ASPE)  Allocates the discount or premium over the bond term  Produces a periodic interest expense equal to a constant percentage of the carrying value of the bond  Using the market rate  The amortization of the discount or the premium is found by comparing the interest expense with the
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