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Chapter 8 Special Acquisitions: Financing a Business with Debt

Chapter 8 Special Acquisitions: Financing a Business with Debt Business Background Capital structure is the mix of debt and equity used to finance a company. DEBT: Loans from banks and insurance companies are often used when borrowing small amounts of capital.

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Chapter 8 Special Acquisitions: Financing a Business with Debt

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  1. Chapter 8 • Special Acquisitions: Financing a Business with Debt

  2. Business Background Capital structure is the mix of debt and equity used to finance a company. • DEBT: • Loans from banks and insurance companies are often used when borrowing small amounts of capital. • Bonds are debt securities issued when borrowing large amounts of money (issued in denominations of $1,000) • Can be issued by either corporations or governmental units.

  3. Notes Payable and Mortgages • When a company borrows money from the bank for longer than a year, the obligation is called a long-term note payable. • A mortgage is a special kind of “note” payable--one issued for property. • These obligations are frequently repaid in equal installments: part of the installment is repayment of principal and part is payment of interest.

  4. Example: Borrowing To Buy Land By Using A Mortgage • ABC Co. signed a $100,000, 3 yr. mortgage (for a piece of land) which carried an 8% annual interest rate. Payments are to be made annually on December 31 of each year for $38,803.35. • How would the mortgage be recorded? • What is the amount of the liability (mortgage payable) after the first payment is made? • Upon signing the mortgage: • Land 100,000 • Mortgage Payable 100,000 • At the time of first payment?

  5. Amortization Schedule Principal Balance Reduction in Principal Payment Interest 100,000.00 38,803.35 38,803.35 38,803.35 8,000.00 30,803.35 69,196.65 5,535.73* 33,267.62 35,929.03 2,874.32** 35,929.03

  6. Time Value of Money • The example of the mortgage demonstrates that money has value over time. • When you borrow $100,000 and pay it back over three years, you have to pay back MORE than $100,000. • Your repayment includes interest--the cost of using someone else’s money. • A dollar received today is worth more than a dollar received in the future. • The sooner your money can earn interest, the faster the interest can earn interest. • Interest is the return you receive for investing your money. You are actually “lending” your money, so you are paid for letting someone else use your money. • Compound interest -- is the interest that your investment earns on the interest that your investment previously earned.

  7. Future value – single sumIf You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years? • i% = 6 PV = 100 N = 5 FV = 100 * 1.3382 PV = 100 FV = 0 5

  8. The Value of a Series of Payments • The previous example had a single payment. Sometimes there is a series of payments. • Annuity: a sequence of equal cash flows, occurring at the end of each period. • When the payments occur at the end of the period, the annuity is also known as an ordinary annuity. • When the payments occur at the beginning of the period, the annuity is called an annuity due.

  9. 0 1 2 3 If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years?This is an ordinary annuity – annuity in arrears – deposits at the end of the period Future Value of an Annuity 1,000 1,000 1,000 FVA = 1,000 * [value from FVA table, 3yrs. 8%] FVA = 1,000 * 3.2464 = $3,246.40

  10. Present value – single sum If you will receive $100 one year from now, what is the PV of that $100 if the relevant interest rate is 6%? • PV = FV (PV factor i, n ) • PV = 100 (0.9434 ) (from PV of $1 table) • PV = $94.34 PV = 94.34 FV = 100 0 1

  11. 0 1 2 3 Present value of ordinary annuity - What is the PV of $1,000 at the end of each of the next 3 years, if the interest rate is 8%? • PVA = 1,000 (3 yrs., 8% factor from the PVA table) • PVA = 1,000 * (2.5771) • PVA = $2,577.10 Present Value 1000 1000 1000

  12. Characteristics of Bonds Payable • Bonds usually involve the borrowing of a large sum of money, called principal. • The principal is usually paid back as a lump sum at the end of the bond period. • Individual bonds are often denominated with a par value, or face value, of $1,000. • Bonds usually carry a stated rate of interest. • Interest is normally paid semiannually. • Interest is computed as: • Interest = Principal × Stated Rate × Time

  13. Measuring Bonds Payable and Interest Expense • The interest rate used to compute the present value is the market interest rate. • Also called yield, effective rate, or true rate. • Creditors demand a certain rate of interest to compensate them for the risks related to bonds. • The stated rate, or coupon rate, is only used to compute the periodic interest payments.

  14. Bond Prices • Example 1 - $1,000, 6% stated rate. • The market rate of interest is 8%. • Who would buy my bond? • Nobody---so I’ll have to sell (issue) it at a discount. • e.g., bondholders would give me something less for the bond. • Example 2 - $1,000, 6% stated rate. • The market rate of interest is 4%. • Who would buy these bonds? • EVERYONE! • So the market will bid up the price of the bond; e.g., I’ll get a little premium for it since it has such good cash flows. • Bondholders will pay more than the face.

  15. Determining the Selling Price • Bonds sell at: • “Par” (100% of face value) • less than par (discount) • more than par (premium) • Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond) • Therefore, if • market rate = stated rate - Bonds sell at par value • market rate > stated rate – Bonds sell at a discount • market rate < stated rate – Bonds sell at a premium

  16. Proceeds Of A Bond Issue – Bond selling price • To calculate the issue price of a bond, you must find the present value of the cash flows associated with the bond. Determine N and i. • Then, find the present value of the interest payments (Principal * stated rate* time) using the market rate of interest. Do this by finding the PV of an annuity. • Then, find the present value of the principal payment at the end of the life of the bonds using the market rate of interest. Do this by finding the PV of a single amount. • Example • On May 1, 1991, Clock Corp. sells $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years, and interest is paid semiannually. The market rate is 8% annually.

  17. INTEREST PAYMENTS PV of an ordinary annuity of $30,000 for 20 periods at an interest rate of 4%: Use a calculator or a PV of an annuity table: 30,000 (PVA,,4%, 20)= 30,000 (13.59033) = 407,710 PRINCIPAL PAYMENT PV of a single amount of $1 million at the end of 20 periods at an interest rate of 4%: Use a calculator or a PV of a single amount table: 1,000,000 (PV,,4%, 20)= 1,000,000 (.45639)= 456,390 Selling price = 407,710 + 456,390 = 864,100 Bonds sold at 86.41 Two parts to the calculations

  18. Recording Bonds Sold at a Discount • How would the issuance of the bonds at a discount be recorded in the journal? • Date Transaction Debit Credit May 1 Cash 864,100 Discount on bond payable 135,900 Bonds payable 1,000,000

  19. Bond Selling Price -- Example • On May 1, 1991, Magic Inc. sells $1,000,000 in bonds having a stated rate of 9%annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually. • Determine bond selling price. • N = 20 I = 4% • {1,000,000 * 4.5% * 13.59033} + { 1,000,000 * 0.45639} • = 611,565 + 456,390 = 1,067,955 • Bonds issued at a premium.

  20. Recording Bonds Sold at a Premium • How would the issuance of the bonds at a premium be recorded in the journal? • Date Transaction Debit Credit May 1 Cash 1,067,955 Premium on bond payable 67,955 Bonds payable 1,000,000

  21. Measuring and Recording Interest on Bonds Issued at a Discount • The discount must be amortized over the outstanding life of the bonds. • The discount amortization increases the periodic interest expense for the issuer. • Two methods are commonly used: • Effective-interest amortization • Straight-line amortization

  22. Discount Amortization • Clock Corporation sold $1,000,000, 6%, 10 –year bonds on January 1, 2000 at 87(sold at 870,000). The market rate of interest = 8%. The bonds pay interest semiannually. • Face value of bonds = $1,000,000 • Discount on bonds = $130,000 • Carrying value of bonds at issuance = selling price = $ 870,000 • The discount will be amortized as interest expense over the life of the bonds • Discount bonds • Interest expense = Cash paid for interest every period + Amount of discount amortized • Interest expense > Cash paid for interest – Why? • Carrying value = Face value – Unamortized discount

  23. Effective Interest Method For Amortizing A Bond Discount

  24. Recording the First Interest Payment on Bonds Sold at a Discount • How would the first interest payment be recorded in the journal? • Date Transaction Debit Credit Interest expense 34,800 Discount on bond payable 4,800 Cash 30,000

  25. Recording the Second Interest Payment on Bonds Sold at a Discount • How would the second interest payment be recorded in the journal? • Date Transaction Debit Credit Interest expense 34,992 Discount on bond payable 4,992 Cash 30,000

  26. Measuring and Recording Interest on Bonds Issued at a Premium • The premium must be amortized over the term of the bonds. • The premium amortization decreases the periodic interest expense for the issuer. • Two methods are commonly used: • Effective-interest amortization • Straight-line amortization

  27. Premium Amortization • Magic Inc. sold $1,000,000, 9%, 10-year bonds on January 1, 2000 at 107 (sold at 1,070,000). The market rate of interest is 8%. • Face value of bonds = 1,000,000 • Premium on bonds = 70,000 • Carrying value of bonds initially = 1,070,000 • The premium will be amortized over the life of the bonds and it will reduce interest expense • Premium bonds • Interest expense = Cash paid for interest every period - Amount of premium amortized • Interest expense < Cash paid for interest – Why? • Carrying value = Face value + Unamortized premium

  28. Effective Interest Method For Amortizing A Bond Premium

  29. Recording the First Interest Payment on Bonds Sold at a Premium • How would the first interest payment be recorded in the journal? • Date Transaction Debit Credit Nov 1 Interest expense 42,800 Premium on bond payable 2,200 Cash 45,000

  30. Recording the Second Interest Payment on Bonds Sold at a Premium • How would the first interest payment be recorded in the journal? • Date Transaction Debit Credit May 1 Interest expense 42,712 Premium on bond payable 2,288 Cash 45,000

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