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This guide provides an overview of essential corporate bond terminology and leasing concepts, focusing on key terms such as secured and unsecured bonds, indentures, and covenant restrictions. It explains strategic financial techniques like staggering maturities, sinking funds, and the implications of different lease types on balance sheets. Key distinctions between capital and operating leases are highlighted alongside tax treatment variations. This resource is designed for finance professionals and students seeking clarity in these critical investment areas.
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Interest Rates & Bonds Prepared by Keldon Bauer FIL 240
Bond Terminology • Corporate bond: • A long-term debt instrument legally obligating the corporation to repay principal and interest according to a prearranged schedule. • Indenture: • A legal contract specifying the rights and restrictions of the borrower and lender. • Trustee is a third party overseeing the indenture.
Bond Security • Secured bond: • Mortgage bond. • Insured. • Unsecured (debenture). • Priority of payment. • Convertible Bonds. • Variable-Rate Bonds. • Putable Bonds
Plans for Paying Off • Staggered Maturities: • Serial payments • Sinking-fund requirement: • A covenant in an indenture for the systematic retirement of bonds prior to maturity. • Call Provision.
Restrictive Covenants • Limitations on Future Borrowings • Restrictions on Dividends • Restrictive Ratios: • Minimum levels of working capital. • Acceptable liquidity and efficiency ratios.
Bond Ratings Junk Bonds
Bond Basics • International bonds • Foreign bond • Eurobonds • Yankee bond
Preferred Stock • Preferred Stock Dividend: • Cumulative on noncumulative. • Preferred Stock Investors: • Generally other corporations since there is a 70% tax exclusion. • Convertible Preferred Stock.
Leasing • Genuine Leases versus Fake Leases • Lease is renting not a purchase. • Definition of Lease: • Remaining life > 20% after lease. • Term of lease ≤ 30 years. • Lessor must earn reasonable return. • Renewal terms must be consistent with value. • Purchase option must be for fair market value. • Leased property cannot be limited-use.
How are leases treated for tax purposes? • Leases are classified by the IRS as either guideline or nonguideline. • For a guideline lease, the entire lease payment is deductible to the lessee. • For a nonguideline lease, only the imputed interest payment is deductible. • Why should the IRS be concerned about lease provisions?
How does leasing affect afirm’s balance sheet? • For accounting purposes, leases are classified as either capital or operating. • Capital leases must be shown directly on the lessee’s balance sheet. • Operating leases, sometimes referred to as off-balance sheet financing, must be disclosed in the footnotes. • Why are these rules in place?
Operating vs. Capital Leases • The lease is a capital lease if at least one of these occurs: • Ownership transfer from lessor to lessee. • Lessee can purchase the property at less than fair market value at end of lease. • The lease runs for a period ≥ 75 percent of asset life. • The PV of the lease payments is ≥ 90% of initial value.
What impact does leasing have on a firm’s capital structure? • Leasing is a substitute for debt. • As such, leasing uses up a firm’s debt capacity.
Assume that Lewis Securities plansto acquire some new equipment having a 6-year useful life. • If the equipment is leased: • Firm could obtain a 4-year lease which includes maintenance. • Lease meets IRS guidelines to expense lease payments. • Rental payment would be $260,000 at the beginning of each year.
Other Information for Lease • Equipment cost: $1,000,000. • Loan rate on equipment = 10%. • Marginal tax rate = 40%. • 3-year MACRS life. • If company borrows and buys, 4 year maintenance contract costs $20,000 at beginning of each year. • Residual value at t = 4: $200,000.
Excel file used in class. • Click here.
