ACCT 328/642 Page 1
Long-Term Debt Overheads
Long-Term Debt
Overview
When companies need to obtain external financing, they have a couple of options:
issue debt or issue equity. Both alternatives provide firms with the money they
need. However, they are very different in form.
Characteristic Debt Equity
Type of cash payment Interest (tax-deductible) Dividends (not deductible)
Nature of cash payment Fixed (interest has to be paid even if Discretionary (ignoring signaling
earnings are lousy) implications)
Voting rights Typically none Yes
Priority in bankruptcy High, depending on type of debt Low
So … given a need to raise money what should firms do, all else equal? Basically,
since the government subsidizes debt (that is, interest is tax-deductible) firms
generally prefer issuing debt to issuing equity. In other words, the after-tax cost of
debt financing is lower than the after-tax cost of equity financing.
As always there are qualifications. Existing debt covenants (which are agreements
between the firm and its lenders that serve to protect lenders’ financial interests)
may prohibit additional debt financing. Furthermore, if the company doesn’t have
positive (or sufficiently high) pre-tax income, some or all of the interest tax shield
may go unused. Generally speaking, however, firms do prefer issuing debt.
Formalities
Bonds and notes may be secured or they may be unsecured. Secured bonds provide
the holder with a claim against specific corporate assets in the event of default.
Unsecured bonds (often referred to as “debentures”) don’t; as a result they generally
are viewed as being more risky and should carry a higher interest rate.
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Long-Term Debt Overheads
When companies decide to issue bonds, they have to have some way of getting
them to market. Generally this involves the use of an underwriter (e.g., Goldman
Sachs, Bear Stearns, etc.) who either (a) guarantees a certain sum to the firm and
assumes the risk of selling the bonds for whatever price they can get; or (b) sells the
bond issue for a commission to be deducted from the proceeds of the sale. Firms
may also sell a bond issue directly to institutional holders, with or without the aid of
an underwriter (private placement).
Valuation and Interest
A bond is valued at the present value of its principal and interest payments,
discounted at the rate appropriate to the bond’s risk class (factoring in firm-specific
factors as well as macroeconomic factors, time to maturity, etc.). This “rate
appropriate to the bond’s risk class” is referred to as the effective rate of interest or
the market rate or yield at issuance.
If the bond’s stated interest rate is less than the market rate at issuance, the issue
will be sold for less than its face value (i.e., at a discount). Why? Because if your
bond is paying 8% and people can get a 9% return from a virtually identical
security, they’re not going to be willing to pay the “full price” for the 8% bond.
What happens, of course, is that the value of the 8% bond decreases until the yield
implicit in the purchase price equals the 9% market return.
So … there are two key things to remember here. First, debt issues are complicated;
as a result, even if the company wants the issue to price exactly at its coupon rate,
there is a good chance that it won’t. Second, if you buy a bond, the rate of return
you will earn if you hold it to maturity is the effective rate … NOT the coupon rate.
If the cash interest payment isn’t always “interest expense,” how do we calculate
interest expense? It’s just like a mortgage payment or a car loan – the interest
expense equals the effective rate when the bonds were issued multiplied by the last
carrying value of the debt.
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Long-Term Debt Overheads
Example
Suppose a company issues debt with a face amount of $10,000 and a coupon rate of
9%. The bonds were sold on January 1, 2000 when the market rate of interest for
comparable securities was 12%. Interest is paid on December 31 of each year and
the bonds mature in five years.
How much cash did the company get from the issue? N=5 years, FV = 10,000,
PMT=900, I=12% … so PV = 8,919.
What’s the interest expense for 2000? At year-end 2000 the last carrying value
was 8,919; interest expense is 12% * 8,919 = 1,070.
How would you record the recognition of interest expense? At the time interest
expense is recognized, you also recognize payment of the coupon amount (or
accrual of the liability). The difference reduces the premium or discount from
the original bond issue.
Interest Expense 1,070
Cash 900
Discount 170
Can you simplify this procedure? Yes. It’s often helpful to put together an
amortization schedule that looks something like this, so that you can determine
what the relevant amounts will be over time.
Coupon Interest Discount CV
Year Payment Expense Amortization 8,919
2000 900 1,070 170 9,089
2001 900 1,091 191 9,279
2002 900 1,114 214 9,493
2003 900 1,139 239 9,732
2004 900 1,168 268 10,000
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Long-Term Debt Overheads
Issue Mechanics
A bond sale is a relatively complicated procedure. Firms have to organize the issue,
arrange for underwriting, file the necessary SEC paperwork, etc. As a result, the
terms of the issue generally are set well in advance of the time that the bonds come
to market. In the interim, market conditions (e.g., interest rates) may change,
affecting the amount of money the firm receives from the issue.
So how does this work? Does the underwriter go out and say, “Hmmm … I need to
determine a selling price, so the first thing I need to figure out is the market rate of
interest for bonds of comparable maturity and risk”? No. The effective rate of
interest typically is the rate that is implicit in the price that the underwriter is able to
secure. In other words, practically speaking, at the point of sale the interest rate
usually is the “plug” in the present value equation.
Underwriting Costs
Related to the above, if an underwriter is used how should the issuing firm account
for the underwriting cost? Rather than include the entire charge in current period
earnings, firms are allowed to amortize the cost equally across the life of the debt
issue. So … at the point of sale a deferred charge (asset) is established. Equal
amounts will be amortized over time until the issue either matures or is
repurchased.
Example
News Release -- February 11, 2003
CSC LAUNCHES $300 MILLION DEBT OFFERING
El Segundo, Calif., Feb. 11--Computer Sciences Corporation (NYSE: CSC) today announced an offering of
$300 million of its 5.00% Notes due February 15, 2013. The notes were priced at 98.746% to yield
5.162%. The sale of the notes is expected to close on February 14, 2003. The proceeds of the sale will be
used for general corporate purposes, including the reduction of the company's outstanding commercial
paper when it matures.
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Take the above example and do the following: (1) verify that the numbers look right
(that is, check to see that the price you calculate from the disclosures is the same as
the price noted in the press release); and (2) show what the accounting would’ve
looked like at issuance.
1) First, assume that this issue, like most, has semi-annual payments. To calculate
the issue price, use FV=300 million, PMT=300m * 5% * ½ (semi-annual) = 7.5
million, N=20 periods (again, semi-annual), and I=5.162% * ½ (again, semi-
annual) … solve for PV and you get 296,240,658. How does that help? Because
a bond’s price usually is stated as a percentage of its par (face) value. So …
296,240,658 / 300,000,000 = 98.75%, which corresponds to the 98.746% in the
press release. Done.
2) If we ignore underwriting costs, the accounting at issuance would’ve looked
something like this:
Cash 296,240,658
Discount on Bonds Payable 3,759,342
Bonds Payable 300,000,000
If we assume that CSC paid the underwriter 0.50% of face value for bringing the
issue to market, the entry would look something like this:
Cash 294,740,658 (296,240,658 – 1,500,000)
Deferred Charge 1,500,000
Discount on Bonds Payable 3,759,342
Bonds Payable 300,000,000
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Long-Term Debt Overheads
Debt Repurchase
Mechanics
If bonds are repurchased in the open market, the repurchase price is the prevailing
market price. If bonds are called (call provisions allow the issuer to repurchase the
issue at a fixed price at some point prior to maturity), the repurchase price is the call
price.
Accounting?? Book an ordinary gain or loss for the difference between the
repurchase price and the current carrying value. Most of these things used to be
classified as extraordinary, but SFAS No. 145 recently did away with that.
Why Do It?
Increase Earnings -- If market interest rates are increasing, debt issued in periods of
lower rates likely will trade at a discount to carrying value. By repurchasing these
issues, firms can book gains and thereby increase bottom-line earnings.
Decrease Required Interest Payments -- If market interest rates are decreasing,
firms may find it advantageous to repurchase existing debt (typically at the
“cheaper” call price) and reissue identical or comparable debt at a lower rate. Such
transactions – typically called “debt refunding” or “refinancing” – usually result in
accounting losses but often benefit the firm in the long run.
Decrease Leverage -- By repurchasing (and not replacing) debt, firms lower their
debt ratios. All else equal, less debt makes existing lenders happier and may make
firms appear less risky to equityholders as well.
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Long-Term Debt Overheads
Example
ABC Corporation issued $10 million face value, 5-year notes on 1/1/02. The notes
were priced to yield 14% and have a 12% coupon. Interest is paid semiannually on
June 30 and December 31, and the notes are callable at 102. On January 1, 2004 the
market rate has dropped to 10%.
If the firm wants to repurchase the bonds on January 1, 2004, should it repurchase
them in the open market or call them?
How will the repurchase affect ABC’s earnings?
Repurchase or Call?
What is cheapest?
Call price is 102 ... or 102% of face value, which is $10,200,000.
Market price is $10,507,569 (FV=10M, PMT=600K, N=6, i=5%).
So ... given that the firm wants to repurchase, it should call the debt rather than
repurchasing it in the open market.
Effect on Earnings?
Carrying value at January 1, 2004 is $9,523,346 (FV=10M, PMT=600K, N=6,
i=7%).
Loss is 10,200,000 - 9,523,346 = $676,654
Journal Entry???
Bonds Payable 10,000,000
Loss 676,654
Cash 10,200,000
Discount 476,654
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Long-Term Debt Overheads
Debt-for-Debt Swaps
With a debt-for-debt swap, a firm offers debtholders the opportunity to swap their
existing debt for a new debt issue. This event is often motivated by its financial
statement effects rather than by any underlying economic benefits.
Example
Suppose a company has a $10 million bond issue outstanding that is due to mature
in two years. The issue was originally sold at par and pays an annual coupon of
10%. Assume, however, that the current prevailing market rate of interest for
obligations of this nature is 14%. With two years left to maturity, the bond issue is
worth $9,341,336 in the open market.
Now … suppose the firm wants to replace the old 10% issue with a new 14% two-
year issue having a face value of $9,341,336. The bondholders should be indifferent
because both issues have a market value of $9,341,336. If the swap goes through,
the firm derives no real economic benefit. However, the accounting for this
transaction would look like this:
Bonds Payable (the old issue) 10,000,000
Bonds Payable (the new issue) 9,341,336
Gain 658,664
Again … the firm derives no real economic benefit from this swap. They are simply
substituting one issue for another issue having an identical market value. However,
if a manager’s bonus is tied to net income he or she would benefit from this
transaction. Or if the company is close to violating its earnings-based debt
covenants, a boost to bottom-line net income might help as well.
In reality, bondholders often have to be enticed to go for the swap (e.g., the new
issue might sell for $9.5 million to sweeten the deal) but a gain would still result for
the company.
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Firms don’t always use swaps of this nature simply to boost earnings. Swaps are
often used to extend debt maturities, to restructure the cash flows associated with
the issue, and to use up operating loss carryforwards (thereby making the gain on
the swap tax-free). Transactions such as these could provide real economic benefits
to the firm. Still, it’s prudent to be skeptical when you see them.
Debt-for-Equity Swaps
Debt-for-equity swaps occur most frequently when market interest rates are
significantly higher than the debt’s coupon rate. Under these circumstances, the
market value of the debt is much lower than the book value (carrying value) of the
debt.
So … if the above scenario obtains and the firm allows its debtholders to trade their
debt for common stock of equivalent market value, a rather large accounting gain is
likely to be recognized. Why? Because the high carrying value is being offset by the
low market value, resulting in a large “plug” figure (the gain) on the right-hand
side.
As might be expected, existing shareholders don’t particularly like these
transactions. Their ownership is diluted and, perhaps more importantly, there is a
shift away from debt in the capital structure (i.e., the interest tax shield is reduced).
In summary, my personal opinion is that even though debt-for-debt and debt-for-
equity swaps may be used “productively,” you should be very suspicious when you
come across them. An awful lot of the time they are used purely for cosmetic
purposes.
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Long-Term Debt Overheads
Financial Distress and Troubled Debt Restructuring
Overview
When firms have financial problems they may have to restructure the terms of their
existing debt agreements.
“Financial problems” may include difficulty in making principal or interest
payments as well as technical violations of accounting-based debt covenants (e.g.,
net worth requirements, maximum leverage requirements, etc.).
If debt covenants are violated, creditors may (1) waive the violation, with the
assumption that things will return to normal in the near future, (2) agree to
restructure the terms of the debt agreement, or (3) accelerate payment of the debt,
which may serve as a big step toward bankruptcy.
In most cases, violations are waived or agreements are restructured because such
arrangements make it more likely, all else equal, that the creditor will recover its
investment in the firm. For example, creditors may change the debt’s interest rate,
extend the maturity, or even allow an exchange of assets or equity in complete
satisfaction of the debt. Events such as these are referred to and accounted for as
Troubled Debt Restructurings (TDRs).
TDRs -- Accounting Issues
The two primary types of TDRs involve (1) full settlement of the debt agreement or
(2) modification of the terms of the debt agreement. Combinations are allowed as
well, but we will not be dealing with them.
Full Settlement -- With a full settlement, the debtor simply swaps assets or equity in
full settlement of the debt. A gain or loss is recognized on the asset transfer itself as
well as on the restructuring.
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Long-Term Debt Overheads
Example
XYZ is having financial problems and its creditor agrees to accept a transfer of land
worth $90,000 (book value of $70,000) in full settlement of the outstanding debt
issue (carrying value of $100,000, issued at face value, with coupon rate of 10%).
(1) Adjust asset to fair market value
Land 20,000
Gain 20,000
(2) Record restructuring
Bonds 100,000
Land 90,000
Gain 10,000
Modification of Terms -- If the agreement’s terms are modified, use a two-step
approach to determine how to account for the restructuring.
(1) Calculate total future cash flows under the new agreement.
(2) Compare (1) to the CV of the debt (plus accrued interest).
Is CV of Debt Future Cash Flows?
If the CV of the debt is higher than the future cash flows under the new agreement,
what does this imply? A current value that is larger than an aggregate future value
implies a negative interest rate ... which of course makes no sense.
Or in other words, if CV > future cash flows, it wouldn’t make much sense for us to
calculate a new interest rate (which would be negative) and effectively recognize
interest revenue (that is, negative interest expense) as the debt is paid off.
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So ... if CV > future cash flows, we realize that something pretty screwy is
happening. As a result, we (1) write down the carrying value of the debt to exactly
equal the future cash flows under the new agreement; (2) recognize a gain for the
difference.
Finally, recognize any future payments -- even those designated as interest
payments -- as reductions in principal. Why? Because we’ve already established
that the interest rate implicit in the agreement is negative ... so we’ve taken the
difference as a gain up front and everything else directly reduces the carrying value
of the debt. Or, equivalently, because the carrying value now exactly equals the sum
of the undiscounted cash flows, the imputed interest rate is zero percent (hence no
future interest expense).
Example
Refer to the first example, except now assume that the creditor reduces the principal
amount by $30,000, keeps the 10% coupon rate, and keeps the two-year term.
Calculate future cash flows under the new agreement -- $70,000 principal +
(70,000*10%*2 years) interest = 84,000
Carrying value of debt is 100,000, so CV > future cash flows -- recognize the
difference as a gain.
Here you would have an entry that looks something like this:
Bonds Payable 16,000
Gain 16,000
The current carrying value of the debt is now 84,000. It will be zeroed out over the
next two years with two $7,000 interest coupon payments (recognized as reductions
in principal) and a final principal payment of $70,000.
What would the coupon payments look like?
Bonds Payable 7,000
Cash 7,000