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Chapter 13

ACTG 3120 Chapter Notes - Chapter 13: Prime Rate, Effective Interest Rate, Balloon Payment Mortgage

Course Code
ACTG 3120
Elizabeth Farrell

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Chapter 13 – Financial Instruments: Long-term Debt
There are 2 different sources of financing: short-term and long term.
Short-term Financing:
-Trade credit:
oThis is extended by suppliers; since and if it is interest free, corporations take advantage of it to put off paying
their trade accounts payable.
oSometimes promissory notes are signed which make the corporation legally obligated to pay the note on or
before the specified date; it can be interest-bearing or non-interest bearing.
-Short-term bank loans:
oThey are usually in the form of operating lines of credit.
Used to help finance working capital and are secured by a lien; receivable and inventory are a
reasonable collateral for loans.
they are due on demand – lender provides appropriate notice and loan must be paid immediately
oGood credit rating companies can issue commercial paper which is a type of short-term promissory note that
is sold in open markets.
oAnother method of financing is to sell or assign company’s receivables to a financial institution.
Long-term Financing:
-Long-term loans: more attractive than short term because:
oShort-term may not be available from period to period; increased cost in comparison
oLT lenders are not shareholders; they have no voting rights thus, does not dilute ownership
oDebt capital is many times easier to obtain than equity capital as equity is higher risk
oInterest expense is tax deductible whereas dividends are not
oA firm is successfully leveraged if they earn a return on borrowed funds that is > the rate is must pay in
- This can be tricky because companies must maintain or grow their earnings in order to pay interest payments and
repay the loan; if earnings decrease, company is paying a greater portion of earnings
- On the other hand, debt is attractive to the lender because they are legally entitled to receive their funds back.
oThey have priority claims to the assets of the company
oSecured debts can tie certain assets of the company with that debt and creditor can seize upon default
- Different forms of long-term debt include: bank loans, notes payable, mortgages, asset-backed loans, publicly issued
bonds – secured or unsecured and long-term leases.
Long-term Bank Financing:
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-Term loans:
oCharacterized as medium-term loans because they are usually for 1.5 to 5 years.
oTangible assets such as equipment, land or buildings would be appropriate collateral for such loans
oThe repayment terms can be structured in 2 ways:
Blended payments
Interest rate is established at the beginning of the loan; each payment includes some interest
and some principal
Designated monthly principal payments + accrued interest on outstanding balance
Interest rate may be fixed at the beginning of the loan or may float with prime interest rate
Principal payment is determined and sometimes at the end, lump sum payment is made known
as a balloon payment.
-Commercial mortgages
oLoans with repayment terms extending beyond 5 years.
oThey are secured against land and buildings and involve regular blended payments, monthly or bimonthly.
oThe amortization period is normally 25 years but the term is for 5 years; after each term the interest and the
loan is reassessed.
- Pension funds are also another alternative as long-term financing
Bond or Debentures Payable
- This is a debt security issued by a corporation or government to secure large amounts of capital on a long-term basis.
oA formal bond agreement is called a bond indenture: specifies the term of the bond and the rights and duties
of both the issuer and the bondholder.
oInvestors receive bond certificates which represent the contractual obligations of the issuer to the investors.
-Debt covenants: restrictions placed on a corporation’s activities as a condition of maintaining the loan.
oif covenant broken, then repayment demanded
othere are 2 types of covenants:
accounting based covenants
Maintaining certain ratios: debt-to-equity, or debt-to-assets
Current ratio
Minimum interest coverage ratio – EBITDA- Earnings before Interest, Tax, Depreciation, and
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