Financing with Long-Term Debt
Profitable firms can use leverage to increase the rate of return on common equity. The primary source of leverage for most firms is the issuance of long-term debt in the form of notes payable (primarily to banks and other financial institutions), bonds payable (to any type of bondholder, including openmarket debt investors), and leases (entered into with property owners, equipment dealers, or finance companies). Debt issuance is evidenced by a bond indenture, promissory note, or lease agreement. These documents will specify:
- promises to pay principal amounts at specified dates.
- promises to pay cash interest (or in the case of leases, lease payments) of specified amounts at specified dates
- call provisions.
- descriptions of property pledged as security
- whether the debt is convertible to another claim and at what rate the conversion will occur.
- covenants and restrictions that specify sinking fund requirements, working capital restrictions, dividend payment restrictions, restrictions on the issuance of new debt, and other restrictions.
This section illustrates the accounting for long-term debt using notes payable. Accounting for bonds payable is similar except for the possibility that bonds may be traded in more active markets, thus having more readily determinable fair values. As discussed in the following sections, fair value of financial instruments is a required disclosure in the notes to the financial statements and an optional measurement for recognition in the financial statements. Note 9, ‘‘Debt Obligations and Commitments’’ (Appendix A), indicates that PepsiCo uses a number of long-term interest-bearing notes to raise capital. Assume that on January 1, 2013, PepsiCo issues a $100 million promissory note to a bank. The note matures in five years on January 1, 2018, and pays 5% interest once a year on January 1. The bank transfers $95.79 million (rounded) to PepsiCo. PepsiCo’s cash flows over the life of the note are as follows (in millions):
The $29.21 million net cash outflow represents the total interest cost on the note. Accrual accounting recognizes the interest cost on the note over the five-year period in an economically meaningful way.
By paying less than $100 million for the note, the bank will earn a return that is greater than the 5% stated interest rate. That is, this investment is sufficiently risky such that the yield or effective interest rate should be higher than 5%, and therefore, the bank ‘‘discounts’’ the note. Effective interest, also known as the yield, yield-to-maturity, or rate of return, is a function of the risk characteristics of the transaction. It is the economic return on the transaction to creditors and the economic cost to debtors. In contrast, cash interest is determined by the coupon rate or stated rate of interest multiplied by the face value of the debt. The stated rate of interest is negotiated in a note or private bond placement or simply presented to potential buyers in a public bond issuance number of factors determine the effective interest rate. A portion of any effective interest rate contains compensation for the use of the lender’s funds. While the funds are on loan, alternative, possibly more profitable opportunities may become available. Also, the effective interest rate will reflect expected inflation, which causes future dollars to have less purchasing power. In addition, if the loan is denominated in a foreign currency, relative changes in economic conditions across countries could result in an unfavorable transformation of foreign currency into the dollar. Finally, firm-specific liquidity and solvency risk explains differences in effective interest rates. You solve for a loan’s effective rate of return (i) using the following formula:
By paying less than $100 million for the note, the bank will earn a return that is greater than the 5% stated interest rate. That is, this investment is sufficiently risky such that the yield or effective interest rate should be higher than 5%, and therefore, the bank ‘‘discounts’’ the note. Effective interest, also known as the yield, yield-to-maturity, or rate of return, is a function of the risk characteristics of the transaction. It is the economic return on the transaction to creditors and the economic cost to debtors. In contrast, cash interest is determined by the coupon rate or stated rate of interest multiplied by the face value of the debt. The stated rate of interest is negotiated in a note or private bond placement or simply presented to potential buyers in a public bond issuance number of factors determine the effective interest rate. A portion of any effective interest rate contains compensation for the use of the lender’s funds. While the funds are on loan, alternative, possibly more profitable opportunities may become available. Also, the effective interest rate will reflect expected inflation, which causes future dollars to have less purchasing power. In addition, if the loan is denominated in a foreign currency, relative changes in economic conditions across countries could result in an unfavorable transformation of foreign currency into the dollar. Finally, firm-specific liquidity and solvency risk explains differences in effective interest rates. You solve for a loan’s effective rate of return (i) using the following formula:
Solving for i results in a yield of 6%.PepsiCo must use the effective interest method to account for the note. The effective interest amortization table is presented in Exhibit 7.5. Amounts in the Cash Interest column are obtained by multiplying the face value of the debt by the stated interest rate of 5%, and amounts in the Effective Interest column are obtained by multiplying the beginning of the period book value of note (previous row) by the 6% effective interest rate charged by the bank. The difference between them is the amortization of the discount.
The beginning book value of $95.79 million represents the amount lent to PepsiCo on 1/1/13. In 2013, PepsiCo incurs a 6% interest charge on its $95.79 million initial borrowing, $5.75 million of effective interest expense. Essentially, the debt has grown by $5.75 million. Because PepsiCo pays only $5 million in cash interest to the bank, the difference between the effective interest expense reported on the income statement and cash interest paid [shown in the Amortization column ($0.75 million)] increases the book value of the debt. Note that the amount of effective interest expense increases each period because the amount owed increases each period as PepsiCo incurs a constant
The beginning book value of $95.79 million represents the amount lent to PepsiCo on 1/1/13. In 2013, PepsiCo incurs a 6% interest charge on its $95.79 million initial borrowing, $5.75 million of effective interest expense. Essentially, the debt has grown by $5.75 million. Because PepsiCo pays only $5 million in cash interest to the bank, the difference between the effective interest expense reported on the income statement and cash interest paid [shown in the Amortization column ($0.75 million)] increases the book value of the debt. Note that the amount of effective interest expense increases each period because the amount owed increases each period as PepsiCo incurs a constant
6% economic interest charge on the debt. The annual increase in the debt is paid off as part of the $100 million maturity payment. Exhibit 7.6 shows the financial statement effects of these transactions and events.
No comments:
Post a Comment