Case study

16

Long-Term Debt and Lease Financing

LEARNING OBJECTIVES

LO 16-1	Analyzing long-term debt requires consideration of the collateral pledged, method of repayment, and other key factors.
LO 16-2	Bond yields are important to bond analysis and are influenced by how bonds are rated by major bond rating agencies.
LO 16-3	An important corporate decision is whether to call in and reissue debt (refund the obligation) when interest rates decline.
LO 16-4	Long-term lease obligations have many characteristics similar to debt and are recognized as a form of indirect debt by the accounting profession.
LO 16-5	When a firm fails to meet its financial obligations, it may be subject to bankruptcy.

For those who invest in the highly rated bonds of firms such as Exxon Mobil, Johnson & Johnson, and Microsoft, there is very little to worry about. You get a higher return than you could get on U.S. Government securities while still being able to sleep soundly at night.

However, for those who invest in bonds of companies in telecommunications or the home building industry, sleep may not come so easily. In the case of the latter, 16 of the 21 largest homebuilders had negative cash flow in 2009 and the outlook was no better for the next 12–24 months. Bond buyer beware when purchasing bonds of companies in cyclical industries.

As one example, D. R. Horton Inc. of Fort Worth, Texas, the second largest homebuilder in the United States, saw its earnings per share drop from a peak value of $4.62 in 2005 to a negative $8.34 in 2008 and a continued loss in 2009. It suffered from high inventories of unsold homes, rising foreclosures, tightened lending standards, and declining home values. By 2012 year-end, the housing market started to recover and D. R. Horton reported earnings per share of $2.77. The improving housing market allowed the company to increase prices on the homes it sold. Between 2008 and 2012, Horton brought down its debt-to-equity ratio from 105 percent to 59 percent, and management stated that the company was in the best position of its existence. By early 2015, Standard & Poor’s had raised Horton’s credit rating to BB.

The Expanding Role of Debt

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The amount of corporate debt has increased over time as corporations grew with the economy. Sometimes the increased use of debt was due to business expansion in capital-intensive industries like airlines and telecommunications. Some companies simply did not generate enough internal funds from operations to fund expansion, so they sold bonds to finance their growth. Other firms decided to recapitalize and repurchased their common stock with funds raised from bond offerings. One thing that hasn’t changed is the cyclical nature of financial leverage ratios as the economy expands and contracts and interest rates move up and down.

One ratio you may remember from Chapter 3 is the times-interest-earned ratio. This ratio divides the operating income (EBIT) by the interest expense and indicates how many times the company can cover its interest expense. The higher the number, the more protected are the interest payments and the bondholders. The interesting thing about this ratio is that it indirectly includes the amount of debt on the balance sheet. As the amount of debt goes up, interest payments usually rise also. However, when interest rates fall, companies can refinance their debt at lower interest rates just like homeowners refinance their homes when mortgage rates decline. So the times--interest-earned ratio is also affected by the interest rates (coupon rates) on their bonds. Two companies can have the same amount of debt but different interest rates associated with their debt, and even though they have the same operating income, their interest coverage ratios would be different.

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In 1977, the average U.S. manufacturing corporation had its interest payment covered by operating earnings at a rate of eight times. By the time the financial crisis ended in 2007–08, the average times interest earned was down to 2.4 times. Figure 16-1 shows times interest earned for Walmart Stores, Inc. since 1998, along with the interest rate on AAA-rated long-term corporate debt. Walmart may be the most financially sound large retailer. Over the last 20 years, interest rates declined dramatically. As interest rates fell, Walmart’s interest coverage initially rose from around 8 percent to almost 16 percent in 2004. However, like many other companies, Walmart took advantage of low interest rates to increase its leverage and to borrow using longer-term debt, which carries a higher interest rate. Although Walmart has more long-term debt than it had in the 1990s, lower average interest costs have allowed the firm to record a times interest earned that is better (higher) in 2015 than it had in the 1990s when it borrowed less.

Figure 16-1 Times interest earned for Walmart Stores, Inc. and AAA long-term debt rates, 1998–2015

The Debt Contract

The corporate bond represents the basic long-term debt instrument for most large U.S. corporations. The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date.

Par Value This is the initial value of the bond. The par value is sometimes referred to as the principal or face value. Most corporate bonds are initially traded in $1,000 units.

Coupon Rate This is the actual interest rate on the bond, usually payable in semi-annual installments. To the extent that interest rates in the market go above or below the coupon rate after the bond has been issued, the market price of the bond will change from the par value.

Maturity Date The maturity date is the final date on which repayment of the bond principal is due.

The bond agreement is supplemented by a much longer document termed a bond indenture. The indenture, often containing over 100 pages of complicated legal wording, covers every detail surrounding the bond issue—including collateral pledged, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation. The corporation appoints a financially independent trustee to administer the provisions of the bond indenture under the guidelines of the Trust Indenture Act of 1939. Let’s examine two items of interest in any bond agreement: the security provisions of the bond and the methods of repayment.

Security Provisions

A secured debt is one in which specific assets are pledged to bondholders in the event of default. Only infrequently are pledged assets actually sold and the proceeds distributed to bondholders. Typically the defaulting corporation is reorganized and existing claims are partially satisfied by issuing new securities to the participating parties. The stronger and better secured the initial claim, the higher the quality of the new security to be received in exchange. When a defaulting corporation is reorganized for failure to meet obligations, existing management may be terminated and, in extreme cases, held legally responsible for any imprudent actions.

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A number of terms are used to denote collateralized or secured debt. Under a mortgage agreement, real property (plant and equipment) is pledged as security for the loan. A mortgage may be senior or junior in nature, with senior requiring satisfaction of claims before payment is given to junior debt. Bondholders may also attach an after-acquired property clause, requiring that any new property be placed under the original mortgage.

You should realize not all secured debt will carry every protective feature, but rather represents a carefully negotiated position including some safeguards and rejecting others. Generally, the greater the protection offered a given class of bondholders, the lower is the interest rate on the bond. Bondholders are willing to assume some degree of risk to receive a higher yield.

Unsecured Debt

A number of corporations issue debt that is not secured by a specific claim to assets. In Wall Street jargon, the name debenture refers to a long-term, unsecured corporate bond. Among the major participants in debenture offerings are such prestigious firms as ExxonMobil, IBM, Dow Chemical, and Intel. Because of the legal problems associated with “specific” asset claims in a secured bond offering, the trend is to issue unsecured debt—allowing the bondholder a general claim against the corporation—rather than a specific lien against an asset.

Even unsecured debt may be divided between high-ranking and subordinated debt. A subordinated debenture is an unsecured bond in which payment to the holder will occur only after designated senior debenture holders are satisfied. The hierarchy of creditor obligations for secured as well as unsecured debt is presented in Figure 16-2, along with consideration of the position of stockholders.

Figure 16-2 Priority of claims

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A classic case of the ranking of bondholders (debtholders) and stockholders took place on June 1, 2009, when General Motors went into bankruptcy. The government provided over $50 billion in funds to GM to help them survive and ultimately come out of bankruptcy as a stronger company. The U.S. government owned 60 percent of the common stock of General Motors in early 2010 and was able to sell a $13.6 billion stake when GM came to the market with an IPO in November of 2010. By December 2013, the U.S government had sold all of its shares in GM.

When GM went into bankruptcy, the common stockholders (with the lowest priority of claims, as shown at the bottom of Figure 16-2) received nothing for their shares. This was quite a disappointment to the stockholders who only two years earlier held shares that were valued at $40 and paying a $2 annual dividend.

Preferred stockholders also received nothing—the next major class, reading up the scale in Figure 16-2, were the unsecured debtholders. They unhappily received 10 cents on the dollar (in this case, there was no distinction between senior and subordinated unsecured debt).

Finally, the secured debtholders (whether senior or junior) were paid off in full with the sell-off of secured assets. The unsecured bondholders were given 10 percent of the new company’s common stock with warrants to purchase another 15 percent in the future.

For a further discussion of payment of claims and the hierarchy of obligations, the reader should see Appendix 16A, “Financial Alternatives for Distressed Firms,” which also covers other bankruptcy considerations.

Methods of Repayment

The method of repayment for bond issues may not always call for one lump-sum disbursement at the maturity date. Some Canadian and British government bonds are perpetual in nature. In 1951, West Shore Railroad Company issued bonds that were scheduled to mature in 2361 (410 years later). More recently, the Coca-Cola Company and the Walt Disney Company have issued “century” bonds that mature in 100 years. Nevertheless most bonds have some orderly or preplanned system of repayment. In addition to the simplest arrangement—a single-sum payment at maturity—bonds may be retired by serial payments, through sinking-fund provisions, through conversion, or by a call feature.

Serial Payments Bonds with serial payment provisions are paid off in installments over the life of the issue. Each bond has its own predetermined date of maturity and receives interest only to that point. Although the total issue may span over 20 years, 15 or 20 different maturity dates may be assigned specific dollar amounts.

Sinking-Fund Provision A less structured but more popular method of debt retirement is through the use of a sinking fund. Under this arrangement semiannual or annual contributions are made by the corporation into a fund administered by a trustee for purposes of debt retirement. The trustee takes the proceeds and purchases bonds from willing sellers. If no willing sellers are available, a lottery system may be used among outstanding bondholders.

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Conversion A more subtle method of reducing debt outstanding is to provide for debt conversion into common stock. Although this feature is exercised at the option of the bondholder, a number of incentives or penalties may be utilized to encourage conversion. The mechanics of convertible bond trading are discussed at length in Chapter 19, “Convertibles, Warrants, and Derivatives.”

Call Feature A call provision allows the corporation to retire or force in the debt issue before maturity. The corporation will pay a premium over par value of 5 to 10 percent—a bargain value to the corporation if bond prices are up. Modern call provisions usually do not take effect until the bond has been outstanding at least 5 to 10 years. Often the call provision declines over time, usually by 0.5 to 1 percent per year after the call period begins. A corporation may decide to call in outstanding debt issues when interest rates on new securities are considerably lower than those on previously issued debt (let’s get the high-cost, old debt off the books).

An Example: Eli Lilly’s 6.77 Percent Bond

Now that we have covered the key features of the bond indenture, let us examine an existing bond. More specific features of this bond are found in Table 16-1, which provides material from the Mergent Industrial Manual. In April 2015, we find that Eli Lilly & Co., one of the largest drug companies in the world, has a 6.77 percent bond due in 2036. The bond carried a Moody’s rating of A1.

As we can see in Table 16-1, the 6.77 percent bond had an original authorized offering of $300 million (third line). The trustee is Citibank, and it is the trustee’s obligation to make sure that Eli Lilly adheres to the terms of the offering. The information in Table 16-1 also provides other pertinent information found in the indenture, such as the interest payment dates (January 1 and July 1), denomination of each bond, security provisions, call features, and high and low bond prices.

Notice that the bond trades above its face value. Corporate bond prices are quoted as a percentage of par value, which is almost always $1,000. This table shows an important relationship between interest rates and bond prices. As interest rates went down after 1996, the price of this long-term bond went up.

Bond Prices, Yields, and Ratings

The financial manager must be sensitive to interest rate changes and price movements in the bond market. For example, the treasurer’s interpretation of market conditions will influence the timing of new issues, the coupon rate offered, and the maturity date. In case you may think bonds maintain stable long-term price patterns, you need merely consider bond pricing during the five-year period 1967–72. When the market interest rate on outstanding 30-year, Aaa corporate bonds went from 5.10 percent to 8.10 percent, the average price of existing bonds dropped 36 percent. A conservative investor would be quite disillusioned to see a $1,000, 5.10 percent bond now quoted at $640.1 Though most bonds are virtually certain to be redeemed at their face value at maturity ($1,000 in this case), this is small consolation to the bondholder who has many decades to wait. At times, bonds also greatly increase in value, such as they did in 1984–85, 1990–92, 1994–95, 2007–08, and 2011–12 when interest rates declined.

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Table 16-1 Eli Lilly’s bond offering

Eli Lilly Bonds Due January 1, 2036

Moody’s Rating: A1

Indenture Date: January 5, 1996

Authorized: $300,000,000

Outstanding: $286,000,000

Securing of Obligation: A direct unsecured obligation

Interest Payable: January 1, July 1

Grace Period: 30 days

Trustee: Citibank

Call Feature: None

Trading Exchange: OTC

Price Range Year	High	Low
2014	$135.40	$127.46
2013	143.96	123.22
2012	152.54	133.18
2011	138.43	113.50
2010	131.26	110.00
2009	123.18	118.72
2008	122.04	117.36
2007	108.36	102.41
2006	106.26	101.38
2005	105.62	93.84
2004	100.28	89.99
2003	119.71	110.82
2002	113.62	107.88
2001	114.45	103.21

Source: Mergent Industrial Manual, 2014 and Nasdaq TRACE.

As indicated in the paragraph above and in Chapter 10, the price of a bond is directly tied to current interest rates. One exception to this rule was discussed at the beginning of the chapter; that is, when bankruptcy becomes a key factor in pricing and valuation. We will look at the more normal case where interest rates are the key factor in determining price.

A bond paying 5.10 percent ($51 a year) will fare quite poorly when the going market rate is 8.10 percent ($81 a year). To maintain a market in the older issue, the price is adjusted downward to reflect current market demands. The longer the life of the issue, the greater the influence of interest rate changes on the price of the bond. The same process will work in reverse if interest rates go down. A 30-year, $1,000 bond initially issued to yield 8.10 percent would go up to almost $1,500 if interest rates declined to 5.10 percent (assuming the bond is not callable). A further illustration of interest rate effects on bond prices is presented in Table 16-2 (on the next page) for a bond paying 12 percent interest. Observe that not only interest rates in the market but also years to maturity have a strong influence on bond prices.

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Table 16-2 Interest rates and bond prices (face value is $1,000 and annual coupon rate is 12%)

Prices are based on semiannual payments. Thus, the annual rate is divided by two and the periods are multiplied by 2. Cash flow inputs are entered as negative values as required by Excel’s PV function.

From 1945 through the early 1980s, the pattern had been for long-term interest rates to move upward (Figure 16-3). However, long-term interest rates have generally been declining since 1982. The figure shows both Moody’s Aaa bond yields for the highest quality corporate bonds and Moody’s Baa bonds, which are three notches lower than the highest investment-grade bonds. The graph does illustrate the pattern of rates over time but also that the highest-quality bonds always have a lower interest rate than lower quality bonds. See the bond rating section for more details on bond quality.

Figure 16-3 Long-term yields on debt

Source: St. Louis Federal Reserve, research.stlouisfed.org

Bond Yields

Bond yields are quoted three different ways: coupon rate, current yield, and yield to maturity. We will apply each to a $1,000 par value bond paying $100 per year interest for 10 years. The bond is currently priced at $900.

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Nominal Yield (Coupon Rate) Stated interest payment divided by the par value.

Current Yield Stated interest payment divided by the current price of the bond.

FINANCIAL CALCULATOR
Bond Yield
Value	Function
10	N
−900	PV
100	PMT
1000	PV
Function	Solution
CPT
I/Y	11.75

Yield to Maturity The yield to maturity is the interest rate that will equate future interest payments and the payment at maturity (principal payment) to the current market price. This represents the concept of the internal rate of return. In the present case, an interest rate of 11.75 percent will equate interest payments of $100 for 10 years and a final payment of $1,000 to the current price of $900. Calculating yield to maturity is discussed in detail in Chapter 10 beginning on page 303.2

When financial analysts speak of bond yields, the general assumption is that they are speaking of yield to maturity. This is deemed to be the most significant measure of return.

Bond Ratings

Both the issuing corporation and the investor are concerned about the rating their bond is assigned by the two major bond rating agencies—Moody’s Investor Service and Standard & Poor’s Corporation. The higher the rating assigned a given issue, the lower the required interest payments are to satisfy potential investors. This is because highly rated bonds carry lower risk. A major industrial corporation may be able to issue a 30-year bond at 5.5 to 6 percent yield to maturity because it is rated Aaa, whereas a smaller, regional firm may only qualify for a B rating and be forced to pay 9 or 10 percent.

As an example of bond rating systems, Moody’s Investor Service provides the following nine categories of ranking:

Aaa    Aa    A    Baa    Ba    B    Caa    Ca    C

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The first two categories of bond ratings represent the highest quality (for example, IBM and Procter & Gamble); the next two, medium to high quality; and so on. The first four categories are considered investment grade, while bonds below that are labeled “junk bonds.” Moody’s also applies numerical modifiers to categories Aa through B: 1 is the highest in a category, 2 is the midrange, and 3 is the lowest. Thus, a rating of Aa2 means the bond is in the midrange of Aa. Standard & Poor’s has a similar letter system with + and − modifiers.

Bonds receive ratings based on the corporation’s ability to make interest payments, its consistency of performance, its size, its debt-equity ratio, its working capital position, and a number of other factors. The yield spread between higher- and lower-rated corporate bonds changes with the economy. If investors are pessimistic about economic events, they will accept as much as 3 percent less return to go into securities of very high quality, whereas in more normal times the spread may be only 1.5 percent.

Examining Actual Bond Ratings

Three actual bond offerings are presented in Table 16-3 to illustrate the various terms we have used.

Table 16-3 Outstanding bond issues

Source: Bloomberg, March 2015.

Recall that the true return on a bond is measured by yield to maturity (the last column of Table 16-3). The Coca-Cola Enterprises bonds are unsecured, as indicated by the term debenture. The bonds are rated AA−, or investment grade, and carry a price of $1,470.63. This price is higher than the par value of $1,000 because the interest rate at time of issue (7.00 percent coupon) is higher than the demanded yield to maturity of 4.72 percent in April 2015. The Microsoft bonds shown are unsecured but senior to other unsecured debt that has been issued. These bonds are rated AAA with a yield to maturity of 3.45 percent. Apple and Toyota bonds have lower credit ratings and slightly higher yields to maturity.

The bonds in Table 16-3 can be refunded if the companies desire. The meaning and benefits of refunding will be made clear in the following section.

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“Open Sesame”—The Story of Alibaba and the Six Bond Tranches Finance in ACTION Managerial

One of the most memorable tales from One Thousand and One Nights is the story of Ali Baba, who opened a door to great riches with the passwords, “Open Sesame.” China’s richest man, Jack Ma, certainly knew the story when he launched the Chinese e-commerce company Alibaba.com in 1999. In September 2014, Alibaba Group Holding executed the largest initial public offering in history, raising $25 billion. Two months later, they were raising capital again in the bond market.

Alibaba provides services similar to Amazon and eBay, but its market value is greater than either one. The company’s biggest market is China, but it has aspirations to expand and compete all over the world. While the company now has other web portals for business-to-consumer and consumer-to-consumer transactions, the group began with Alibaba.com, now the world’s largest business-to-business e-commerce site. Before Alibaba.com, if you wanted to find a Chinese supplier of 5000 tiny electric motors, you needed a contact in China who could visit manufacturers to negotiate a price. Now, you go to Alibaba.com where dozens of suppliers post product availability for 500 or 500,000 units.

Alibaba’s big bond offering was for $8 billion, but the offering consisted of six “tranches.” Each tranche was a specific class of bond within the offering with a different due date and different terms. The five fixed-rate tranches were:

• $1,000 million 1.625% notes due in 3 years

• $2,250 million 2.500% notes due in 5 years

• $1,500 million 3.125% notes due in 7 years

• $2,250 million 3.600% notes due in 10 years

• $700 million 4.500% notes due in 20 years

By spreading out the maturities in the offering, Alibaba locked in its financing costs for several years. The company also issued a sixth tranche of $300 million in floating rate notes denominated in Singapore dollars.

One of the challenges faced by multinational corporations is matching financing decisions with their expected operating activities. Alibaba’s use of multiple tranches that mixed fixed-rates with floating rates, offered multiple maturities with differing coupon amounts, and promised repayments in a mix of currencies suggests a significant level of financial sophistication, either by the firm or by its investment bank.

The Refunding Decision

Assume you are the financial vice president for a corporation that has issued bonds at 11.75 percent, only to witness a drop in interest rates to 9.5 percent. If you believe interest rates will rise rather than sink further, you may wish to redeem the expensive 11.75 percent bonds and issue new debt at the prevailing 9.5 percent rate. This process is labeled a refunding operation. It is made feasible by the call provision that enables a corporation to buy back bonds at close to par, rather than at high market values, when interest rates are declining.

A Capital Budgeting Problem

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The refunding decision involves outflows in the form of financing costs related to redeeming and reissuing securities, and inflows represented by savings in annual interest costs and tax savings. In the present case, we shall assume the corporation issued $10 million worth of 11.75 percent debt with a 25-year maturity and the debt has been on the books for five years. The corporation now has the opportunity to buy back the old debt at 10 percent above par (the call premium) and to issue new debt at 9.5 percent interest with a 20-year life. The underwriting cost for the old issue was $125,000, and the underwriting cost for the new issue is $200,000. We shall also assume the corporation is in the 35 percent tax bracket and uses a 6 percent discount rate for refunding decisions. Since the savings from a refunding decision are certain—unlike the savings from most other capital budgeting decisions—we use the aftertax cost of new debt as the discount rate, rather than the more generalized cost of capital.3 Actually, in this case, the aftertax cost of new debt is 9.5 percent (1 − Tax rate), or 9.5% × 0.65 = 6.18%. We round to 6 percent. The facts in this example are restated as follows.

Let’s go through the capital budgeting process of defining our outflows and inflows and determining the net present value.

Step A—Outflow Considerations

1. Payment of call premium—The first outflow is the 10 percent call premium on $10 million, or $1 million. This prepayment penalty is necessary to call in the original issue. Being an out-of-pocket tax-deductible expense, the $1 million cash expenditure will cost us only $650,000 on an aftertax basis. We multiply the expense by (1 − Tax rate) to get the aftertax cost.

$1,000,000 (1 − T) = $1,000,000 (1 − 0.35) = $650,000

Net cost of call premium = $650,000

2. Underwriting cost on new issue—The second outflow is the $200,000 underwriting cost on the new issue. The actual cost is somewhat less because the payment is tax-deductible, though the write-off must be spread over the life of the bond. While the actual $200,000 is being spent now, equal tax deductions of $10,000 a year will occur over the next 20 years (in a manner similar to depreciation).

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The tax savings from a noncash write-off are equal to the amount times the tax rate. For a company in the 35 percent tax bracket, $10,000 of annual tax deductions will provide $3,500 of tax savings each year for the next 20 years. The present value of these savings is the present value of a $3,500 annuity for 20 years at 6 percent interest, which is approximately $40,145, as shown in the margin.

The net cost of underwriting the new issue is the actual expenditure now, minus the present value of future tax savings as indicated below.

FINANCIAL CALCULATOR
PV of Annuity
Enter	Function
20	N
6	I/Y
0	FV
−3500	PMT
Function	Solution
CPT
PV	40,144.72

Actual expenditure	$200,000
− PV of future tax savings	40,145
Net cost of underwriting expense on the new issue	$159,855

Step B—Inflow Considerations

The major inflows in the refunding decision are related to the reduction of annual interest expense and the immediate write-off of the underwriting cost on the old issue.

3. Cost savings in lower interest rates—The corporation will enjoy a 2.25 percentage point drop in interest rates, from 11.75 percent to 9.50 percent, on $10 million of bonds.

11.75% × $10,000,000	$1,175,000
9.50% × $10,000,000	950,000
Savings	$   225,000

FINANCIAL CALCULATOR
PV of Annuity
Enter	Function
20	N
6	I/Y
0	FV
−146250	PMT
Function	Solution
CPT
PV	1,677,475.98

Since we are in the 35 percent tax bracket, this is equivalent to $146,250 of aftertax benefits per year for 20 years. We have taken the savings and multiplied by one minus the tax rate to get the annual aftertax benefits.

$225,000 (1 − T)

$225,000 (1 − 0.35)

$146,250

Applying a 6 percent discount rate for a 20-year annuity yields an approximate present value of $1,677,476, as shown in the margin.

Cost savings in lower interest rates

$1,677,476

4. Underwriting cost on old issue—There is a further cost savings related to immediately writing off the remaining underwriting costs on the old bonds. Note that the initial amount of $125,000 was spent five years ago and was to be written off for tax purposes over 25 years at $5,000 per year. Since five years have passed, $100,000 of old underwriting costs have not been amortized as indicated in the following:

Original amount	$125,000
Written off over five years	25,000
Unamortized old underwriting costs	$100,000

A tax benefit is associated with the immediate write-off of old underwriting costs, which we shall consider shortly.

FINANCIAL CALCULATOR
PV of Annuity
Enter	Function
20	N
6	I/Y
0	FV
−5000	PMT
Function	Solution
CPT
PV	57,349.61

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Note, however, that this is not a total gain. We would have gotten the $100,000 additional write-off eventually if we had not called in the old bonds. By calling them in now, we simply take the write-off sooner. If we extended the write-off over the remaining life of the bonds, we would have taken $5,000 a year for 20 years. Discounting the 20-year annuity at 6 percent, we get an approximate present value of $57,350, as shown in the margin.

Thus, we are getting a write-off of $100,000 now, rather than a present value of future write-offs of $57,350. The gain in immediate tax write-offs is $42,650. The tax savings from a noncash tax write-off equal the amount times the tax rate. Since we are in the 35 percent tax bracket, our savings from this write-off are $14,928. The following calculations, which were discussed earlier, are necessary to arrive at $14,928.

Immediate write-off	$100,000
− PV of future write-off	57,350
Gain from immediate write-off	$ 42,650

        $42,650 (T)

        $42,650 (0.35) = $14,928

Net gain from the underwriting on the old issue      $14,928

Step C—Net Present Value

We now compare our outflows and our inflows from the prior pages.

The refunding decision has a positive net present value, suggesting that interest rates have dropped to a sufficiently low level to indicate refunding is in order. The only question is: Will interest rates go lower—indicating an even better time for refunding? There is no easy answer. Conditions in the financial markets must be carefully considered.

A number of other factors could be plugged into the problem. For example, there could be overlapping time periods in the refunding procedure when both issues are outstanding and the firm is paying double interest (hopefully for less than a month). The dollar amount in these cases, however, tends to be small and is not included in the analysis.

In working problems, you should have minimum difficulty if you follow the four suggested calculations on the prior pages. In each of the four calculations we had the following tax implications:

1. Payment of call premium—the cost equals the amount times (1 − Tax rate) for this cash tax-deductible expense.

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2. Underwriting costs on new issue—we pay an amount now and then amortize it over the life of the bond for tax purposes. This subsequent amortization is similar to depreciation and represents a noncash write-off of a tax-deductible expense. The tax saving from the amortization is equal to the amount times the tax rate.

3. Cost savings in lower interest rates—cost savings are like any form of income, and we will retain the cost savings times (1 − Tax rate).

4. Underwriting cost on old issue—once again, the writing off of underwriting costs represents a noncash write-off of a tax-deductible expense. The tax savings from the amortization are equal to the amount times the tax rate.

Other Forms of Bond Financing

As interest rates continued to show increasing volatility in the 1980s and early 1990s, two innovative forms of bond financing became very popular and remain so today. We shall examine the zero-coupon rate bond and the floating rate bond.

The zero-coupon rate bond, or zero-coupon bond, as the name implies, does not pay interest. It is, however, sold at a deep discount from face value. The return to the investor is the difference between the investor’s cost and the face value received at the end of the life of the bond. From an investor’s point of view, an advantage of the zero coupon bond is that there are no coupons to reinvest and the yield to maturity on the bond is locked in for the life of the bond. A dramatic case of a zero-coupon bond was an issue offered by PepsiCo Inc. in 1982, in which the maturities ranged from 6 to 30 years. The 30-year $1,000 par value issue could be purchased for $26.43, providing a yield of approximately 12.75 percent. The purchase price per bond of $26.43 represented only 2.643 percent of the par value. A million dollars worth of these 30-year bonds could be initially purchased for a mere $26,430.

The advantage to the corporation is that there is immediate cash inflow to the firm, without any outflow until the bonds mature. Furthermore, the difference between the initial bond price and the maturity value may be amortized for tax purposes by the corporation over the life of the bond. This means the corporation will be taking annual deductions without current cash outflow.

From the investor’s viewpoint, the zero-coupon bonds allow him or her to lock in a multiplier of the initial investment. For example, investors may know they will get three times their investment after a specified number of years. The major drawback is that the annual increase in the value of bonds is taxable as ordinary income as it accrues, even though the bondholder does not get any cash flow until maturity. For this reason most investors in zero-coupon rate bonds have tax-exempt or tax-deferred status (pension funds, foundations, charitable organizations, individual retirement accounts, and the like).

The prices of the bonds tend to be highly volatile because of changes in interest rates. Even though the bonds provide no annual interest payment, there is still an initial yield to maturity that may prove to be too high or too low with changes in the marketplace.

The bonds listed in Table 16-4 are examples of zero-coupon bonds. The bonds sell at a considerable discount from par value of $1,000 since they all have some time remaining until maturity.

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Table 16-4 Zero-coupon bonds

Source: Bloomberg, March 2015.

Another interesting type of bond issue is the floating rate bond (long popular in European capital markets). In this case, instead of a change in the price of the bond, the interest rate paid on the bond changes with market conditions (usually monthly or quarterly). Thus, a bond that was initially issued to pay 9 percent may lower the interest payments to 6 percent during some years and raise them to 12 percent in others. The interest rate is usually tied to some overall market rate, such as the yield on Treasury bonds (perhaps 120 percent of the going yield on long-term Treasury bonds).

The price of a floating rate bond stays close to the $1,000 par value since the coupon adjusts with changes in market rates. The advantage to investors in floating rate bonds is that they have a constant (or almost constant) market value for the security, even though interest rates vary. An exception is that floating rate bonds often have broad limits that interest payments cannot exceed. For example, the interest rate on a 6 percent initial offering may not be allowed to go over 10 percent or below 3 percent. If long-term interest rates dictated an interest payment of 12 percent, the payment would still remain at 10 percent. This could cause some short-term loss in market value. To date, floating rate bonds have been relatively free of this problem. From an investor’s point of view, the best time to own floating rate bonds is when interest rates are expected to rise.

Zero-coupon rate bonds and floating rate bonds still represent a relatively small percentage of the total market of new debt offerings. Nevertheless, they should be part of a basic understanding of long-term debt instruments.

Advantages and Disadvantages of Debt

The financial manager must consider whether debt will contribute to or detract from the firm’s operations. In certain industries, such as airlines, very heavy debt utilization is a way of life, whereas in other industries (drugs, photographic equipment) reliance is placed on other forms of capital.

Benefits of Debt

The advantages of debt may be enumerated as:

1. Interest payments are tax-deductible. Because the maximum corporate tax rate is in the mid-30 percent range, the effective aftertax cost of interest is approximately two-thirds of the dollar amount expended.

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2. The financial obligation is clearly specified and of a fixed nature (with the exception of floating rate bonds). Contrast this with selling an ownership interest in which stockholders have open-ended participation in profits; however, the amount of profits is unknown.

3. In an inflationary economy, debt may be paid back with “cheaper dollars.” A $1,000 bond obligation may be repaid in 10 or 20 years with dollars that have shrunk in value by 50 or 60 percent. In terms of “real dollars,” or purchasing power equivalents, one might argue that the corporation should be asked to repay something in excess of $2,000. Presumably, high interest rates in inflationary periods compensate the lender for loss in purchasing power, but this is not always the case.

4. The use of debt, up to a prudent point, may lower the cost of capital to the firm. To the extent that debt does not strain the risk position of the firm, its low aftertax cost may aid in reducing the weighted overall cost of financing to the firm.

Drawbacks of Debt

Finally, we must consider the disadvantages of debt:

1. Interest and principal payment obligations are set by contract and must be met, regardless of the economic position of the firm.

2. Indenture agreements may place burdensome restrictions on the firm, such as maintenance of working capital at a given level, limits on future debt offerings, and guidelines for dividend policy. Although bondholders generally do not have the right to vote, they may take virtual control of the firm if important indenture provisions are not met.

3. Utilized beyond a given point, debt may depress outstanding common stock values.

Eurobond Market

A market with an increasing presence in world capital markets is that in Eurobonds. A Eurobond may be defined as a bond payable in the borrower’s currency but sold outside the borrower’s country. The Eurobond is usually sold by an international syndicate of investment bankers and includes bonds sold by companies in Switzerland, Japan, the Netherlands, Germany, the United States, and Britain, to name the most popular countries. An example might be a bond of a U.S. company, payable in dollars and sold in London, Paris, Tokyo, or Frankfurt. Disclosure requirements in the Eurobond market are less demanding than those of the Securities and Exchange Commission or other domestic regulatory agencies. Examples of several Eurobonds are presented in Table 16-5.

Leasing as a Form of Debt

When a corporation contracts to lease an oil tanker or a computer and signs a noncancelable, long-term agreement, the transaction has all the characteristics of a debt obligation. Long-term leasing was not recognized as a debt obligation in the early post–World War II period, but since the mid-60s there has been a strong movement by the accounting profession to force companies to fully divulge all information about leasing obligations and to indicate the equivalent debt characteristics.

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Table 16-5 Examples of Eurobonds

Source: Bloomberg, March 2015.

This position was made official for financial reporting purposes as a result of Statement of Financial Accounting Standards (SFAS) No. 13, issued by the Financial Accounting Standards Board (FASB). This statement said certain types of leases must be shown as long-term obligations on the financial statements of the firm. Before SFAS No. 13, lease obligations could merely be divulged in footnotes to financial statements, and large lease obligations did not have to be included in the debt structure (except for the upcoming payment). Consider the case of Firm ABC, whose balance sheet is shown in Table 16-6.

Table 16-6 Balance sheet ($ millions)

Before the issuance of SFAS No. 13, a footnote to the financial statements might have indicated a lease obligation of $12 million a year for the next 15 years, with a present value of $100 million. With the issuance of SFAS No. 13, this information was moved directly to the balance sheet, as indicated in Table 16-7.

We see that both a new asset and a new liability have been created, as indicated by the asterisks. The essence of this treatment is that a long-term, noncancelable lease is tantamount to purchasing the asset with borrowed funds, and this should be reflected on the balance sheet. Note that between the original balance sheet (Table 16-6) and the revised balance sheet (Table 16-7), the total-debt-to-total-assets ratio has gone from 50 percent to 66.7 percent.

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Table 16-7 Revised balance sheet ($ millions)

*New entries

Though this represents a substantial increase in the ratio, the impact on the firm’s credit rating or stock price may be minimal. To the extent that the financial markets are efficient, the information was already known by analysts who took the data from footnotes or other sources and made their own adjustments. Nevertheless, corporate financial officers fought long, hard, and unsuccessfully to keep the lease obligation off the balance sheet. They tend to be much less convinced about the efficiency of the marketplace.

Capital Lease versus Operating Lease

Not all leases must be capitalized (present-valued) and placed on the balance sheet. This treatment is necessary only when substantially all the benefits and risks of ownership are transferred in a lease. Under these circumstances, we have a capital lease (also referred to as a financing lease). Identification as a capital lease and the attendant financial treatment are required whenever any one of the four following conditions is present:

1. The arrangement transfers ownership of the property to the lessee (the leasing party) by the end of the lease term.

2. The lease contains a bargain purchase price at the end of the lease. The option price will have to be sufficiently low so exercise of the option appears reasonably certain.

3. The lease term is equal to 75 percent or more of the estimated life of the leased property.

4. The present value of the minimum lease payments equals 90 percent or more of the fair value of the leased property at the inception of the lease.4

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A lease that does not meet any of these four criteria is not regarded as a capital lease, but as an operating lease. An operating lease is usually short term and is often cancelable at the option of the lessee (the party using the asset). Furthermore, the lessor (the owner of the asset) may provide for the maintenance and upkeep of the asset, since he or she is likely to get it back. An operating lease does not require the capitalization, or presentation, of the full obligation on the balance sheet. Operating leases are used most frequently with such assets as automobiles and office equipment, while capital leases are used with oil drilling equipment, airplanes and rail equipment, certain forms of real estate, and other long-term assets. The greatest volume of leasing obligations is represented by capital leases.

Income Statement Effect

The capital lease calls not only for present-valuing the lease obligation on the balance sheet but also for treating the arrangement for income statement purposes as if it were somewhat similar to a purchase-borrowing arrangement. Thus, under a capital lease, the intangible asset account previously shown in Table 16-7 as “Leased property under capital lease” is amortized, or written off, over the life of the lease with an annual expense deduction. Also, the liability account shown in Table 16-7 as “Obligation under capital lease” is written off through regular amortization, with an implied interest expense on the remaining balance. Thus, for financial reporting purposes the annual deductions are amortization of the asset, plus the implied interest expense on the remaining present value of the liability. Though the actual development of these values and accounting rules is best deferred to an accounting course, you should understand the close similarity between a capital lease and borrowing to purchase an asset, for financial reporting purposes.

An operating lease, on the other hand, usually calls for an annual expense deduction equal to the lease payment, with no specific amortization, as is indicated in Appendix 16B, “Lease versus Purchase Decision,” at the end of this chapter.

Advantages of Leasing

Why is leasing so popular? It has emerged as a trillion-dollar industry, with such firms as Clark Equipment, GE Capital, and U.S. Leasing International providing an enormous amount of financing. Major reasons for the popularity of leasing include the following:

1. The lessee may lack sufficient funds or the credit capability to purchase the asset from a manufacturer, who is willing, however, to accept a lease arrangement or to arrange a lease obligation with a third party.

2. The provisions of a lease obligation may be substantially less restrictive than those of a bond indenture.

3. There may be no down payment requirement, as would generally be the case in the purchase of an asset (leasing allows for a larger indirect loan).

4. The lessor may possess particular expertise in a given industry—allowing for expert product selection, maintenance, and eventual resale. Through this process, the negative effects of obsolescence may be reduced.

5. Creditor claims on certain types of leases, such as real estate, are restricted in bankruptcy and reorganization proceedings. Leases on chattels (non–real estate items) have no such limitation.

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There are also some tax factors to be considered. Where one party to a lease is in a higher tax bracket than the other party, certain tax advantages, such as depreciation write-off or research-related tax credits, may be better utilized. For example, a wealthy party may purchase an asset for tax purposes, then lease the asset to another party in a lower tax bracket for actual use. Also, lease payments on the use of land are tax-deductible, whereas land ownership does not allow a similar deduction for depreciation.

Finally, a firm may wish to engage in a sale-leaseback arrangement, in which assets already owned by the lessee are sold to the lessor and then leased back. This process provides the lessee with an infusion of capital, while allowing the lessee to continue to use the asset. Even though the dollar costs of a leasing arrangement are often higher than the dollar costs of owning an asset, the advantages cited above may outweigh the direct cost factors.

SUMMARY

As a first consideration, corporate bonds may be secured by a lien on a specific asset or may carry an unsecured designation, indicating the bondholder possesses a general claim against the corporation. A special discussion of the hierarchy of claims for firms in financial distress is presented in Appendix 16A.

Both the issuing corporation and the investor are concerned about the rating their bond is assigned by the two major bond rating agencies—Moody’s Investor Service and Standard & Poor’s Corporation. The higher the rating assigned a given issue, the lower the required interest payments needed to satisfy potential investors. This is because highly rated bonds carry lower risk.

Bond refundings may take place when interest rates are going down. The financial manager must consider whether the savings in interest will compensate for the additional cost of calling in the old issue and selling a new one.

The zero-coupon rate bond, as the name implies, does not pay interest. It is, however, sold at a deep discount from face value. The return to the investor is the difference between the investor’s cost and the face value received at the end of the life of the bond.

A second type of innovative bond issue is the floating rate bond. In this case, instead of a change in the price of the bond, the interest rate paid on the bond changes with market conditions (usually monthly or quarterly).

When a corporation contracts to lease an oil tanker or a computer and signs a noncancelable, long-term agreement, the transaction has all the characteristics of a debt obligation, and should be recognized as such on the financial statements of the firm.

LIST OF TERMS

par value 505

maturity date 505

indenture 505

secured debt 505

mortgage agreement 505

after-acquired property clause 506

debenture 506

subordinated debenture 506

serial payment 507

sinking fund 507

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call provision 508

coupon rate 510

current yield 510

yield to maturity 510

bond rating 511

refunding 513

zero-coupon rate bond 517

floating rate bond 518

Eurobond 519

capital lease 521

operating lease 521

DISCUSSION QUESTIONS

1. Corporate debt has been expanding very dramatically in the last three decades. What has been the impact on interest coverage, particularly since 1977? (LO16-1)

2. What are some specific features of bond agreements? (LO16-1)

3. What is the difference between a bond agreement and a bond indenture? (LO16-1)

4. Discuss the relationship between the coupon rate (original interest rate at time of issue) on a bond and its security provisions. (LO16-1)

5. Take the following list of securities and arrange them in order of their priority of claims: (LO16-1)

Preferred stock	Senior debenture
Subordinated debenture	Senior secured debt
Common stock	Junior secured debt

6. What method of “bond repayment” reduces debt and increases the amount of common stock outstanding? (LO16-3)

7. What is the purpose of serial repayments and sinking funds? (LO16-1)

8. Under what circumstances would a call on a bond be exercised by a corporation? What is the purpose of a deferred call? (LO16-3)

9. Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds? (LO16-2)

10. What is the difference between the following yields: coupon rate, current yield, yield to maturity? (LO16-2)

11. How does the bond rating affect the interest rate paid by a corporation on its bonds? (LO16-2)

12. Bonds of different risk classes will have a spread between their interest rates. Is this spread always the same? Why? (LO16-2)

13. Explain how the bond refunding problem is similar to a capital budgeting decision. (LO16-3)

14. What cost of capital is generally used in evaluating a bond refunding decision? Why? (LO16-3)

15. Explain how the zero-coupon rate bond provides return to the investor. What are the advantages to the corporation? (LO16-2)

16. Explain how floating rate bonds can save the investor from potential embarrassments in portfolio valuations. (LO16-2)

17. Discuss the advantages and disadvantages of debt. (LO16-1)

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18. What is a Eurobond? (LO16-1)

19. What do we mean by capitalizing lease payments? (LO16-4)

20. Explain the close parallel between a capital lease and the borrow–purchase decision from the viewpoint of both the balance sheet and the income statement. (LO16-4)

PRACTICE PROBLEMS AND SOLUTIONS

Bond yields

(LO16-2)

1. The Gorden Corporation has a bond outstanding with $85 annual interest payments, a market price of $860, and a maturity date in seven years.

Compute the following:

a. The coupon rate.

b. The current yield.

c. The yield to maturity.

Refunding decision

(LO16-3)

2. The Hudson Corporation has a $15 million bond obligation outstanding which it is considering refunding. Though the bonds were initially issued at 9 percent, the interest rates on similar issues have declined to 7.2 percent. The bonds were originally issued for 15 years and have 10 years remaining. The new issue would be for 10 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new $15,000,000 issue is $200,000, and the underwriting cost on the old issue was $450,000. The company is in a 30 percent tax bracket, and it will use a 5 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision.

Should the old issue be refunded with new debt?

Solutions

FINANCIAL CALCULATOR
Bond Yield
Value	Function
7	N
−860	PV
85	PMT
1000	FV
Function	Solution
CPT
I/Y	11.52

1. a. $85 interest/$1,000 par = 8.5% coupon rate

b. $85 interest/$860 market price = $9.88% current yield

c. See the nearby calculator keystrokes. The yield to maturity is 11.52%.

2. Outflows

1. Payment of call premium (cost)

$15,000,000 × 9% = $1,350,000

$1,350,000 × (1 − 0.30) = $945,000

2. Underwriting cost on new issue

Actual expenditure $200,000

Amortization of cost ($200,000/10) × 0.30

$20,000 × (0.30) = $6,000 tax savings per year

PV of future tax savings (n = 10, i = 5%)

$6,000 × 7.722 = $46,332

Actual expenditure	$200,000
− PV of future tax savings	46,332
Net cost of underwriting expense on new issue	$153,668

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Inflows

3. Cost savings in lower interest rates

9% (interest on old bonds) × $15,000,000 =	$1,350,000 per year
7.2% (interest on new bonds) × $15,000,000 =	1,080,000 per year
Savings per year	$270,000
Savings per year after tax $270,000 (1 − 0.3)	$189,000
PV of future savings (n = 10, i = 5%)
$189,000 × 7.722 =	$1,459,458

4. Underwriting cost on old issue

Original amount	$450,000
Annual write-off $450,000/15 =	30,000
Amount written off over initial 5 years at $30,000 per year	$150,000
Unamortized old underwriting cost	$300,000
PV of future write-off of $30,000 per year:
n = 10 (years remaining i = 5%)
PV = 30,000 × 7.722 = $231,660

Take the difference between the unamortized old underwriting costs of $300,000 and the PV of the future write-off of $231,600.

Immediate write-off of unamortized old underwriting costs	$300,000
− PV of future write-off	231,660
Net gain from immediate write-off	$ 68,340
Multiply this figure by the tax rate to get the net tax benefit	$ 68,340
of the immediate write-off	0.30
	$ 20,502

Summarize the inflows and outflows to get the net present value.

Due to the positive net present value, the old issue should be refunded.

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PROBLEMS

 Selected problems are available with Connect. Please see the preface for more information.

Basic Problems

Assume the par value of the bonds in the following problems is $1,000 unless otherwise specified.

Bond yields

(LO16-2)

1. The Pioneer Petroleum Corporation has a bond outstanding with an $85 annual interest payment, a market price of $800, and a maturity date in five years. Find the following:

a. The coupon rate.

b. The current rate.

c. The yield to maturity.

Bond yields

(LO16-2)

2. Preston Corporation has a bond outstanding with an $80 annual interest payment, a market price of $1,250, and a maturity date in 10 years. Assume the par value of the bonds is $1,000. Find the following:

a. The coupon rate.

b. The current rate.

c. The yield to maturity.

Bond yields

(LO16-2)

3. Harold Reese must choose between two bonds: Bond X pays $95 annual interest and has a market value of $900. It has 10 years to maturity. Bond Z pays $95 annual interest and has a market value of $920. It has two years to maturity.

a. Compute the current yield on both bonds.

b. Which bond should he select based on your answer to part a?

c. A drawback of current yield is that it does not consider the total life of the bond. For example, the yield to maturity on Bond X is 11.21 percent. What is the yield to maturity on Bond Z?

d. Has your answer changed between parts b and c of this question?

Bond yields

(LO16-2)

4. An investor must choose between two bonds: Bond A pays $72 annual interest and has a market value of $925. It has 10 years to maturity. Bond B pays $62 annual interest and has a market value of $910. It has two years to maturity. Assume the par value of the bonds is $1,000.

a. Compute the current yield on both bonds.

b. Which bond should she select based on your answer to part a?

c. A drawback of current yield is that it does not consider the total life of the bond. For example, the yield to maturity on Bond A is 8.33 percent. What is the yield to maturity on Bond B?

d. Has your answer changed between parts b and c of this question in terms of which bond to select?

Secured vs. unsecured debt

(LO16-1)

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5. Match the yield to maturity in column 2 with the security provisions (or lack thereof) in column 1. Higher returns tend to go with greater risk.

(1) Security Provision	(2) Yield to Maturity
a. Debenture	a. 6.85%
b. Secured debt	b. 8.20%
c. Subordinated debenture	c. 7.76%

Bond value

(LO16-2)

6. The Florida Investment Fund buys 58 bonds of the Gator Corporation through a broker. The bonds pay 10 percent annual interest. The yield to maturity (market rate of interest) is 12 percent. The bonds have a 10-year maturity.

Using an assumption of semiannual interest payments:

a. Compute the price of a bond (refer to “Semiannual Interest and Bond Prices” in Chapter 10 for review if necessary).

b. Compute the total value of the 58 bonds.

Bond value

(LO16-2)

7. Cox Media Corporation pays an 11 percent coupon rate on debentures that are due in 10 years. The current yield to maturity on bonds of similar risk is 8 percent. The bonds are currently callable at $1,110. The theoretical value of the bonds will be equal to the present value of the expected cash flow from the bonds.

a. Find the market value of the bonds using semiannual analysis.

b. Do you think the bonds will sell for the price you arrived at in part a? Why?

Effect of bond rating change

(LO16-2)

8. The yield to maturity for 10-year bonds is as follows for four different bond rating categories:

Aaa	9.40%	Aa2	10.00%
Aa1	9.60%	Aa3	10.60%

The bonds of Falter Corporation were rated as Aaa and issued at par a few weeks ago. The bonds have just been downgraded to Aa2. Determine the new price of the bonds, assuming a 10-year maturity and semiannual interest payments. (Refer to “Semiannual Interest and Bond Prices” in Chapter 10 for a review if necessary.)

Interest rates and bond ratings

(LO16-2)

9. Twenty-five-year B-rated bonds of Parker Optical Company were initially issued at a 12 percent yield. After 10 years the bonds have been upgraded to Aa2. Such bonds are currently yielding 10 percent to maturity. Use Table 16-2 to determine the price of the bonds with 15 years remaining to maturity. (You do not need the bond ratings to enter the table; just use the basic facts of the problem.)

Interest rates and bond ratings

(LO16-2)

10. A previously issued A2, 15-year industrial bond provides a return three-fourths higher than the prime interest rate of 11 percent. Previously issued A2 public utility bonds provide a yield of three-fourths of a percentage point higher than previously issued A2 industrial bonds of equal quality. Finally, new issues of A2 public utility bonds pay three-fourths of a percentage point more than previously issued A2 public utility bonds.Page 529

What should be the interest rate on a newly issued A2 public utility bond?

Zero-coupon rate bond

(LO16-2)

11. A 17-year, $1,000 par value zero-coupon rate bond is to be issued to yield 7 percent.

a. What should be the initial price of the bond? (Take the present value of $1,000 for 17 years at 7 percent.)

b. If immediately upon issue, interest rates dropped to 6 percent, what would be the value of the zero-coupon rate bond?

c. If immediately upon issue, interest rates increased to 9 percent, what would be the value of the zero-coupon rate bond?

Zero-coupon bond yield

(LO16-2)

12. Assume a zero-coupon bond that sells for $403 and will mature in 10 years at $1,250. What is the effective yield to maturity? (Compute PVIF and go to Appendix B for the 10-year figure to find the answer, or compute FVIF and go to Appendix A for the 10-year figure to find the answer. Either approach will work.)

Floating rate bond

(LO16-2)

13. You buy an 8 percent, 25-year, $1,000 par value floating rate bond in 1999. By the year 2004, rates on bonds of similar risk are up to 11 percent. What is your one best guess as to the value of the bond?

Intermediate Problems

Effect of inflation on purchasing power of bond

(LO16-2)

14. Seventeen years ago, the Archer Corporation borrowed $6,500,000. Since then, cumulative inflation has been 65 percent (a compound rate of approximately 3 percent per year).

a. When the firm repays the original $6,500,000 loan this year, what will be the effective purchasing power of the $6,500,000? (Hint: Divide the loan amount by one plus cumulative inflation.)

b. To maintain the original $6,500,000 purchasing power, how much should the lender be repaid? (Hint: Multiply the loan amount by one plus cumulative inflation.)

c. If the lender knows he will receive only $6,500,000 in payment after 17 years, how might he be compensated for the loss in purchasing power? A descriptive answer is acceptable.

Profit potential associated with margin

(LO16-2)

15. A $1,000 par value bond was issued 25 years ago at a 12 percent coupon rate. It currently has 15 years remaining to maturity. Interest rates on similar obligations are now 8 percent.

a. What is the current price of the bond? (Look up the answer in Table 16-2.)

b. Assume Ms. Bright bought the bond three years ago when it had a price of $1,050. What is her dollar profit based on the bond’s current price?

c. Further assume Ms. Bright paid 30 percent of the purchase price in cash and borrowed the rest (known as buying on margin). She used the interest payments from the bond to cover the interest costs on the loan. How much of the purchase price of $1,050 did Ms. Bright pay in cash?

d. What is Ms. Bright’s percentage return on her cash investment? Divide the answer to part b by the answer to part c.

e. Explain why her return is so high.

Loss exposure and profit potential

(LO16-2)

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16. A $1,000 par value bond was issued 20 years ago at a 9 percent coupon rate. It currently has 5 years remaining to maturity. Interest rates on similar debt obligations are now 10 percent.

a. Compute the current price of the bond using an assumption of semiannual payments.

b. If Mr. Robinson initially bought the bond at par value, what is his percentage loss (or gain)?

c. Now assume Mrs. Pinson buys the bond at its current market value and holds it to maturity, what will her percentage return be?

d. Although the same dollar amounts are involved in part b and c, explain why the percentage gain is larger than the percentage loss.

Advanced Problems

Advanced refunding decision

(LO16-3)

17. The Bowman Corporation has a $18 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 10 percent, the interest rates on similar issues have declined to 8.5 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new $18,000,000 issue is $530,000, and the underwriting cost on the old issue was $380,000. The company is in a 35 percent tax bracket, and it will use an 8 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision.

a. Calculate the present value of total outflows.

b. Calculate the present value of total inflows.

c. Calculate the net present value.

d. Should the old issue be refunded with new debt?

Refunding decision

(LO16-3)

18. The Robinson Corporation has $43 million of bonds outstanding that were issued at a coupon rate of 11¾ percent seven years ago. Interest rates have fallen to 10¾ percent. Mr. Brooks, the vice president of finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 2.4 percent of the total bond value. The underwriting cost on the new issue will be 1.7 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a 9 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter. (Consider the bond to be seven years old for purposes of computing the premium.) Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole number.

a. Compute the discount rate.

b. Calculate the present value of total outflows.

c. Calculate the present value of total inflows.

d. Calculate the net present value.

Call premium

(LO16-3)

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19. The Sunbelt Corporation has $40 million of bonds outstanding that were issued at a coupon rate of 12⅞ percent seven years ago. Interest rates have fallen to 12 percent. Mr. Heath, the vice president of finance, does not expect rates to fall any further. The bonds have 18 years left to maturity, and Mr. Heath would like to refund the bonds with a new issue of equal amount also having 18 years to maturity. The Sunbelt Corporation has a tax rate of 36 percent. The underwriting cost on the old issue was 2.5 percent of the total bond value. The underwriting cost on the new issue will be 1.8 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with an 8 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter (consider the bond to be seven years old for purposes of computing the premium). Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole number. Should the Sunbelt Corporation refund the old issue?

Capital lease or operating lease

(LO16-4)

20. The Deluxe Corporation has just signed a 168-month lease on an asset with a 19-year life. The minimum lease payments are $1,300 per month ($15,600 per year) and are to be discounted back to the present at a 9 percent annual discount rate. The estimated fair value of the property is $165,000.

a. Calculate the lease period as a percentage to the estimated life of the leased property.

b. Calculate the present value of lease payments as a percentage to the fair value of the property.

c. Should the lease be recorded as a capital lease or an operating lease? Use criteria 3 and 4 for a capital lease.

Balance sheet effect of leases

(LO16-4)

21. The Ellis Corporation has heavy lease commitments. Prior to SFAS No. 13, it merely footnoted lease obligations in the balance sheet, which appeared as follows:

The footnotes stated that the company had $14 million in annual capital lease obligations for the next 20 years.

a. Discount these annual lease obligations back to the present at a 10 percent discount rate (round to the nearest million dollars).

b. Construct a revised balance sheet that includes lease obligations, as in Table 16-7.

c. Compute total debt to total assets on the original and revised balance sheets.

d. Compute total debt to equity on the original and revised balance sheets.

e. In an efficient capital market environment, should the consequences of SFAS No. 13, as viewed in the answers to parts c and d, change stock prices and credit ratings?

f. Comment on management’s perception of market efficiency (the viewpoint of the financial officer).

Determining size of lease payment

(LO16-4)

22. The Hardaway Corporation plans to lease a $740,000 asset to the O’Neil Corporation. The lease will be for 11 years.

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a. If the Hardaway Corporation desires a 13 percent return on its investment, how much should the lease payments be?

b. If the Hardaway Corporation is able to take a 10 percent deduction from the purchase price of $740,000 and will pass the benefits along to the O’Neil Corporation in the form of lower lease payments, (related to the Hardaway Corporation in the form of lower initial net cost), how much should the revised lease payments be? The Hardaway Corporation desires a 13 percent return on the 11-year lease.

COMPREHENSIVE PROBLEM

Broadband Inc.

(Bond prices, refunding)

(LO16-2 & 16-3)

Barton Simpson, the chief financial officer of Broadband Inc. could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 6 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago.

Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par, and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life.

Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.

a. First compute the price of the old bonds in the open market. Use the valuation procedures for a bond that were discussed in Chapter 10 (use annual analysis). Determine the price of a single $1,000 par value bond.

b. Compare the price in part a to the 8 percent call premium over par value. Which appears to be more attractive in terms of reacquiring the old bonds?

c. Now do the standard bond refunding analysis as discussed in this chapter. Is the refunding financially feasible?

d. In terms of the refunding decision, how should Barton be influenced if he thinks interest rates might go down even more?

WEB EXERCISE

1. We will examine the debt ratios for two airlines. First go to finance.yahoo.com. In the “Get Quotes” box, enter LUV for Southwest Airlines. Scroll down along the left margin and click on “Balance Sheet.”

2. Compute the ratio of Long-Term Debt to Total Stockholders’ Equity for the three years shown. Do the same thing for Total Liabilities to Total Stockholders’ Equity.

3. Go back to the summary page and follow the same process for Delta Air Lines (DAL). Write a paragraph summary of the two airlines’ debt ratios. Which company is in better condition?

Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a Web site. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for.

APPENDIX | 16A

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Financial Alternatives for Distressed Firms

A firm may be in financial distress because of technical insolvency or bankruptcy. The first term refers to a firm’s inability to pay its bills as they come due. Thus, a firm may be technically insolvent, even though it has a positive net worth; there simply may not be sufficient liquid assets to meet current obligations. The second term, bankruptcy, indicates the market value of a firm’s assets are less than its liabilities and the firm has a negative net worth. Under the law, either technical insolvency or bankruptcy may be adjudged as a financial failure of the business firm.

Many firms do not fall into either category but are still suffering from extreme financial difficulties. Perhaps they are rapidly approaching a situation in which they cannot pay their bills or their net worth will soon be negative.

Firms in the types of financial difficulty discussed in the first two paragraphs may participate in out-of-court settlements or in-court settlements through formal bankruptcy proceedings under the National Bankruptcy Act.

Out-of-court settlements, where possible, allow the firm and its creditors to bypass certain lengthy and expensive legal procedures. If an agreement cannot be reached on a voluntary basis between a firm and its creditors, in-court procedures will be necessary.

Out-of-Court Settlement

Out-of-court settlements may take many forms. Four alternatives will be examined. The first is an extension, in which creditors agree to allow the firm more time to meet its financial obligations. A new repayment schedule will be developed, subject to the acceptance of the creditors.

A second alternative is a composition, under which creditors agree to accept a fractional settlement of their original claim. They may be willing to do this because they believe the firm is unable to meet its total obligations and they wish to avoid formal bankruptcy procedures. In the case of either a proposed extension or a composition, some creditors may not agree to go along with the arrangements. If their claims are relatively small, major creditors may allow them to be paid off immediately in full to hold the agreement together. If their claims are large, no out-of-court settlement may be possible, and formal bankruptcy proceedings may be necessary.

A third type of out-of-court settlement may take the form of a creditor committee established to run the business. Here the parties involved assume management can no longer effectively conduct the affairs of the firm. Once the creditors’ claims have been partially or fully settled, a new management team may be brought in to replace the creditor committee. The outgoing management may be willing to accept the imposition of a creditor committee only when formal bankruptcy proceedings appear likely and they wish to avoid that stigma. Sometimes creditors are unwilling to form such a committee because they fear lawsuits from other dissatisfied creditors or from common or preferred stockholders.

A fourth type of out-of-court settlement is an assignment, in which assets are liquidated without going through formal court action. To effect an assignment, creditors must agree on liquidation values and the relative priority of claims. This is not an easy task.

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In actuality, there may be combinations of two or more of the above-described out-of-court procedures. For example, there may be an extension as well as a composition, or a creditor committee may help to establish one or more of the alternatives.

In-Court Settlements—Formal Bankruptcy

When it is apparent an out-of-court settlement cannot be reached, the next step is formal bankruptcy. Bankruptcy proceedings may be initiated voluntarily by the company or, alternatively, by creditors.

Once the firm falls under formal bankruptcy proceedings, a referee is appointed by the court to oversee the activities. The referee becomes the arbitrator of the proceedings, whose actions and decisions are final, subject only to review by the court. A trustee will also be selected to properly determine the assets and liabilities of the firm and to carry out a plan of reorganization or liquidation for the firm.

Reorganization If the firm is to be reorganized (under the Bankruptcy Act’s Chapter 11 restructuring), the plan must prove to be fair and feasible. An internal reorganization calls for an evaluation of current management and operating policies. If current management is shown to be incompetent, it will probably be discharged and replaced by new management. An evaluation and possible redesign of the current capital structure is also necessary. If the firm is top-heavy with debt (as is normally the case), alternate securities, such as preferred or common stock, may replace part of the debt.1 Any restructuring must be fair to all parties involved.

An external reorganization, in which a merger partner is found for the firm, may also be considered. The surviving firm must be deemed strong enough to carry out the financial and management obligations of the joint entities. Old creditors and stockholders may be asked to make concessions to ensure that a feasible arrangement is established. Their motivation is that they hope to come out further ahead than if such a reorganization were not undertaken. Ideally the firm should be merged with a strong firm in its own industry, although this is not always possible. The savings and loan and banking industries have been particularly adept at merging weaker firms with stronger firms within the industry.

Liquidation

A liquidation or sale of assets may be recommended when an internal or external reorganization does not appear possible and it is determined that the assets of the firm are worth more in liquidation than through a reorganization. Priority of claims becomes extremely important in a liquidation, because it is unlikely that all parties will be fully satisfied in their demands.

The priority of claims in a bankruptcy liquidation is as follows:

1. Cost of administering the bankruptcy procedures (lawyers get in line first).

2. Wages due workers if earned within three months of filing the bankruptcy petition. The maximum amount is $600 per worker.

3. Taxes due at the federal, state, or local level.

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4. Secured creditors to the extent that designated assets are sold to meet their claims. Secured claims that exceed the sales value of the pledged assets are placed in the same category as other general creditor claims.

5. General or unsecured creditors are next in line. Examples of claims in this category are those held by debenture (unsecured bond) holders, trade creditors, and bankers who have made unsecured loans.

There may be senior and subordinated positions within category 5, indicating that subordinated debt holders must turn over their claims to senior debt holders until complete restitution is made to the higher-ranked category. Subordinated debenture holders may keep the balance if anything is left over after that payment.

6. Preferred stockholders.

7. Common stockholders.

The priority of claims 4 through 7 is similar to that presented in Figure 16-2 of the chapter.

Let us examine a typical situation to determine “who” should receive “what” under a liquidation in bankruptcy. Assume the Mitchell Corporation has a book value and liquidation value as shown in Table 16A-1. Liabilities and stockholders’ claims are also presented.

Table 16A-1 Financial data for the Mitchell Corporation

Assets
	Book Value	Liquidation Value
Accounts receivable	$   200,000	$160,000
Inventory	410,000	240,000
Machinery and equipment	240,000	100,000
Building and plant	450,000	200,000
	$1,300,000	$700,000

Liabilities and Stockholders’ Claims
Liabilities:
Accounts payable	$   300,000
First lien, secured by machinery and equipment*	200,000
Senior unsecured debt	400,000
Subordinated debentures	200,000
Total liabilities	$1,100,000
Stockholders’ claims:
Preferred stock	50,000
Common stock	150,000
Total stockholders’ claims	$   200,000
Total liabilities and stockholders’ claims	$1,300,000

*A lien represents a potential claim against property. The lien holder has a secured interest in the property.

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We see that the liquidation value of the assets is far less than the book value ($700,000 versus $1.3 million). Also, the liquidation value of the assets will not cover the total value of liabilities ($700,000 compared to $1.1 million). Since all liability claims will not be met, it is evident that lower-ranked preferred stockholders and common stockholders will receive nothing.

Before a specific allocation is made to the creditors (those with liability claims), the three highest priority levels in bankruptcy must first be covered. That would include the cost of administering the proceedings, allowable past wages due to workers, and overdue taxes. For the Mitchell Corporation, we shall assume these total $100,000. Since the liquidation value of assets was $700,000, that would leave $600,000 to cover creditor demands, as indicated in the left-hand column of Table 16A-2.

Table 16A-2 Asset values and claims

Before we attempt to allocate the values in the left-hand column of Table 16A-2 to the right-hand column, we must first identify any creditor claims that are secured by the pledge of a specific asset. In the present case, there is a first lien on the machinery and equipment of $200,000. Referring back to Table 16A-1, we observe that the machinery and equipment has a liquidation value of only $100,000. The secured debt holders will receive $100,000, with the balance of their claim placed in the same category as the unsecured debt holders. In Table 16A-3, we show asset values available for unsatisfied secured claims and unsecured debt (top portion) and the extent of the remaining claims (bottom portion).

Table 16A-3 Asset values available for unsatisfied secured claims and unsecured debt holders—and their remaining claims

Asset values:
Asset values in liquidation	$   700,000
Administrative costs, wages, and taxes	100,000
Remaining asset values	$   600,000
Payment to secured creditors	− 100,000
Amount available to unsatisfied secured claims and unsecured debt	$   500,000
Remaining claims of unsatisfied secured debt and unsecured debt:
Secured debt (unsatisfied first lien)	$   100,000
Accounts payable	300,000
Senior unsecured debt	400,000
Subordinated debentures	200,000
	$1,000,000

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In comparing the available asset values and claims in Table 16A-3, it appears that the settlement on the remaining claims should be at a 50 percent rate ($500,000/$1,000,000). The allocation will take place in the manner presented in Table 16A-4.

Table 16A-4 Allocation procedures for unsatisfied secured claims and unsecured debt

Each category receives 50 percent as an initial allocation. However, the subordinated debenture holders must transfer their $100,000 initial allocation to the senior debt holders in recognition of their preferential position. The secured debt holders and those having accounts payable claims are not part of the senior-subordinated arrangement and, thus, hold their initial allocation position.

Finally, in Table 16A-5, we show the total amounts of claims, the amount received, and the percent of the claim that was satisfied.

Table 16A-5 Payments and percent of claims

The $150,000 in column (3) for secured debt represents the $100,000 from the sale of machinery and equipment, and $50,000 from the allocation process in Table 16A-4. The secured debt holders and senior unsecured debt holders come out on top in terms of percent of claim satisfied (it is coincidental that they are equal). Furthermore, the subordinated debt holders and, as previously mentioned, the preferred and common stockholders receive nothing. Naturally, allocations in bankruptcy will vary from circumstance to circumstance. Working problem 16A-1 will help to reinforce many of the liquidation procedure concepts discussed in this section.

List of Terms

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technical insolvency 533

bankruptcy 533

extension 533

composition 533

creditor committee 533

assignment 533

internal reorganization 534

external reorganization 534

liquidation 534

Discussion Questions

16A–1. What is the difference between technical insolvency and bankruptcy? (LO16-5)

16A–2. What are four types of out-of-court settlements? Briefly describe each. (LO16-5)

16A–3. What is the difference between an internal reorganization and an external reorganization under formal bankruptcy procedures? (LO16-5)

16A–4. What are the first three priority items under liquidation in bankruptcy? (LO16-5)

Problem

Settlement of claims in bankruptcy liquidation

(LO16-5)

16A–1. The trustee in the bankruptcy settlement for Titanic Boat Co. lists the following book values and liquidation values for the assets of the corporation. Liabilities and stockholders’ claims are also shown.

a. Compute the difference between the liquidation value of the assets and the liabilities.

b. Based on the answer to part a, will preferred stock or common stock participate in the distribution?

Assets
	Book Value	Liquidation Value
Accounts receivable	$1,400,000	$1,200,000
Inventory	1,800,000	900,000
Machinery and equipment	1,100,000	600,000
Building and plant	4,200,000	2,500,000
Total assets	$8,500,000	$5,200,000

Liabilities and Stockholders’ Claims
Liabilities:
Accounts payable	$2,800,000
First lien, secured by machinery and equipment	900,000
Senior unsecured debt	2,200,000
Subordinated debenture	1,700,000
Total liabilities	$7,600,000
Stockholders’ claims:
Preferred stock	$   250,000
Common stock	650,000
Total stockholders’ claims	$   900,000
Total liabilities and stockholders’ claims	$8,500,000

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c. Assuming the administrative costs of bankruptcy, workers’ allowable wages, and unpaid taxes add up to $400,000, what is the total remaining asset value available to cover secured and unsecured claims?

d. After the machinery and equipment are sold to partially cover the first lien secured claim, how much will be available from the remaining asset liquidation values to cover unsatisfied secured claims and unsecured debt?

e. List the remaining asset claims of unsatisfied secured debt holders and unsecured debt holders in a manner similar to that shown at the bottom portion of Table 16A-3.

f. Compute a ratio of your answers in part d and e. This will indicate the initial allocation ratio.

g. List the remaining claims (unsatisfied secured and unsecured) and make an initial allocation and final allocation similar to that shown in Table 16A-4. Subordinated debenture holders may keep the balance after full payment is made to senior debt holders.

h. Show the relationship of amount received to total amount of claim in a similar fashion to that of Table 16A-5. Remember to use the sales (liquidation) value for machinery and equipment plus the allocation amount in part g to arrive at the total received on secured debt.

APPENDIX | 16B

Lease-versus-Purchase Decision

The classic lease-versus-purchase decision does not fit a capital leasing decision given the existence of SFAS No. 13 and the similar financial accounting and tax treatment accorded to a capital lease and borrowing to purchase. Nevertheless, the classic lease-versus-purchase decision is still appropriate for the short-term operating lease.

Assume a firm is considering the purchase of a $6,000 asset in the three-year MACRS category (with a four-year write-off) or entering into two sequential operating leases, for two years each. Under the operating leases, the annual payments would be $1,400 on the first lease and $2,600 on the second lease. If a firm purchased the asset, it would pay $1,893 annually to amortize a $6,000 loan over four years at 10 percent interest. This is based on the use of Appendix D for the present value of an annuity.

The firm is in a 30 percent tax bracket. In doing our analysis, we look first at the aftertax costs of the operating lease arrangements in Table 16B-1. The tax shield in column (2) indicates the amount the lease payments will save us in taxes. In column (3) we see the net aftertax cost of the lease arrangement.

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Table 16B-1 Aftertax cost of operating leases

For the borrowing and purchasing decision, we must consider not only the amount of the payment but also separate out those items that are tax-deductible. First we consider interest and then depreciation.

In Table 16B-2, we show an amortization table to pay off a $6,000 loan over four years at 10 percent interest with $1,893 annual payments. In column (1), we show the beginning balance for each year. This is followed by the annual payment in column (2). We then show the amount of interest we will pay on the beginning balance at a 10 percent rate in column (3). In column (4), we subtract the interest payment from the annual payment to determine how much is applied directly to the repayment of principal. In column (5), we subtract the repayment of principal from the beginning balance to get the year-end balance.

Table 16B-2 Amortization table

After determining our interest payment schedule, we look at the depreciation schedule that would apply to the borrow–purchase decision. Using the three-year MACRS depreciation category (with the associated four-year write-off), the asset is depreciated at the rates indicated in Table 16B-3.

We now bring our interest and depreciation schedules together in Table 16B-4 to determine the aftertax cost, or cash outflow, associated with the borrow–purchase decision.

The interest and depreciation charges are tax-deductible expenses and provide a tax shield against other income. The total deductions in column (4) are multiplied by the tax rate of 30 percent to show the tax shield benefits in column (5). In column (6), we subtract the tax shield from the payments to get the net aftertax cost, or cash outflow.

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Table 16B-3 Depreciation schedule

Table 16B-4 Aftertax cost of borrow–purchase decision

Finally, we compare the cash outflows from leasing to the cash outflows from borrowing and purchasing. To consider the time value of money, we discount the annual values at an interest rate of 7 percent. This is the aftertax cost of debt to the firm, and it is computed by multiplying the interest rate of 10 percent by (1 − Tax rate). Because the costs associated with both leasing and borrowing are contractual and certain, we use the aftertax cost of debt as the discount rate, rather than the normal cost of capital. The overall analysis is presented in Table 16B-5.

Table 16B-5 Net present value comparison

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The borrow–purchase alternative has a lower present value of aftertax costs ($4,422 versus $4,646), which would appear to make it the more desirable alternative. However, many of the previously discussed qualitative factors that support leasing must also be considered in the decision-making process.

Problem

Lease versus purchase decision

(LO16-4)

16A–1. Howell Auto Parts is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If the company purchases the asset, the cost will be $10,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent.

The other alternative is to sign two operating leases, one with payments of $2,600 for the first two years, and the other with payments of $4,600 for the last two years. In your analysis, round all values to the nearest dollar.

a. Compute the aftertax cost of the leases for the four years.

b. Compute the annual payment for the loan (round to the nearest dollar).

c. Compute the amortization schedule for the loan. (Disregard a small difference from a zero balance at the end of the loan—due to rounding.)

d. Determine the depreciation schedule (see Table 12-9).

e. Compute the aftertax cost of the borrow–purchase alternative.

f. Compute the present value of the aftertax cost of the two alternatives. Use a discount rate of 8 percent.

g. Which alternative should be selected, based on minimizing the present value of aftertax costs?

1Bond prices are generally quoted as a percentage of original par value. In this case, the quote would read 64.

2A formula may be used to approximate yield to maturity.

3A minority opinion would be that there is sufficient similarity between the bond refunding decision and other capital budgeting decisions to disallow any specialized treatment. Also note that although the bondholders must still bear some risk of default, for which they are compensated, the corporation assumes no risk.

4The discount rate used for this test is the leasing firm’s new cost of borrowing or the lessor’s (the firm that owns the asset) implied rate of return under the lease. The lower of the two must be used when both are known.

1Another possibility is income bonds, in which interest is payable only if earned.