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Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
Chapter 06 Valuation & Characteristics Of Bonds
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Chapter 06 Valuation & Characteristics Of Bonds

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FINANCIAL MANAGEMENT PART 6

FINANCIAL MANAGEMENT PART 6

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  • 1. The Valuation and Characteristics of Bonds Chapter 6
  • 2. The Basis of Value <ul><li>Securities are worth the present value of the future cash income associated with owning them </li></ul><ul><ul><li>The security should sell in financial markets for a price very close to that value </li></ul></ul><ul><ul><ul><li>However, I might think Security A has a different intrinsic value then someone else thinks, because we have different estimates for the </li></ul></ul></ul><ul><ul><ul><ul><li>Discount rate </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Expected future cash flows </li></ul></ul></ul></ul>
  • 3. The Basis for Value <ul><li>Investing </li></ul><ul><ul><li>Using a resource to benefit the future rather than for current satisfaction </li></ul></ul><ul><ul><ul><li>Putting money to work to earn more money </li></ul></ul></ul><ul><ul><ul><ul><li>Common types of investments </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Debt—lending money </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Equity—buying an ownership in a business </li></ul></ul></ul></ul></ul><ul><li>A return is what the investor receives divided by what s/he invests </li></ul><ul><ul><li>Debt investors receive interest </li></ul></ul>
  • 4. The Basis for Value <ul><li>Rate of return is the interest rate that equates the present value of its expected future cash flows with its current price </li></ul><ul><ul><li>PV = FV  (1 + k) </li></ul></ul><ul><ul><li>Return is also known as </li></ul></ul><ul><ul><ul><li>Yield </li></ul></ul></ul><ul><ul><ul><li>Interest </li></ul></ul></ul>return
  • 5. Bond Valuation <ul><li>A bond issue represents borrowing from many lenders at one time under a single agreement </li></ul><ul><ul><li>While one person may not be willing to lend a single company $10 million, 10,000 investors may be willing to lend the firm $1,000 each </li></ul></ul>
  • 6. Bond Terminology and Practice <ul><li>A bond’s term (or maturity) is the time from the present until the principal is to be returned </li></ul><ul><ul><li>Bond’s mature on the last day of their term </li></ul></ul><ul><li>A bond’s face value (or par) represents the amount the firm intends to borrow (the principal) at the coupon rate of interest </li></ul><ul><ul><li>Bonds typically pay interest (coupon rate) every six months </li></ul></ul><ul><ul><li>Bonds are non-amortized (meaning the principal is repaid at once when the bond matures rather than being repaid in increments throughout the bond’s life) </li></ul></ul>
  • 7. Interest Rates for Various Treasury Securities of Differing Maturities Note that bonds with a longer maturity generally have a higher interest rate and that interest rates on Treasury securities move in tandem.
  • 8. Bond Valuation—Basic Ideas <ul><li>Adjusting to interest rate changes </li></ul><ul><ul><li>Bonds are sold in both primary (original sale) and secondary markets (subsequent trading among investors) </li></ul></ul><ul><ul><li>Interest rates change all the time </li></ul></ul><ul><ul><li>Most bonds pay a fixed interest rate </li></ul></ul><ul><ul><ul><li>What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change? </li></ul></ul></ul>
  • 9. Bond Valuation—Basic Ideas <ul><li>You buy a 20 year, $1000 par bond today for par (meaning you pay $1,000 for it) when the coupon rate is 10% </li></ul><ul><ul><li>This implies that your required rate of return was 10% </li></ul></ul><ul><ul><li>For that purchase price, you are promised 20 years of coupon payments of $100 each, and a principal repayment of $1,000 in 20 years </li></ul></ul><ul><li>After you’ve held the bond investment for a week, you decide that you need the money (cash) more than you need the investment </li></ul><ul><ul><li>You decide to sell the bond </li></ul></ul><ul><ul><li>Unfortunately, interest rates have risen </li></ul></ul><ul><ul><li>Other investors now have a required rate of return of 11% </li></ul></ul><ul><ul><ul><li>They can buy new bonds with an 11% coupon rate in the market for $1,000 </li></ul></ul></ul><ul><ul><ul><li>Will they buy your bond from you for $1,000? </li></ul></ul></ul><ul><ul><ul><li>NO! They’ll buy it for less than $1,000 </li></ul></ul></ul>
  • 10. Determining the Price of a Bond <ul><li>Remember, Intrinsic Value is the present value of all future expected cash flows </li></ul><ul><li>With a bond, predicting the future cash flows is somewhat ‘easy,’ because the promised cash flows are specified. </li></ul><ul><ul><li>Interest (usually) </li></ul></ul><ul><ul><li>Principal (usually) </li></ul></ul><ul><ul><li>Maturity (in years) </li></ul></ul>In practice most bonds pay interest semi-annually.
  • 11. Determining the Price of a Bond 0 1 5 10 $100 a year for 10 years $100 $1,000 ? $1,100 Example Q: A bond has 10 years to maturity, a par value of $1,000, and a coupon rate of 10%. What cash flows are expected from the bond? A:
  • 12. Determining the Price of a Bond <ul><li>The Bond Valuation Formula </li></ul><ul><ul><li>The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment </li></ul></ul>
  • 13. Figure 6.1: Cash Flow Time Line for a Bond This is a single sum. This is an ordinary annuity.
  • 14. Determining the Price of a Bond <ul><li>Two Interest Rates and One More </li></ul><ul><ul><li>Coupon rate </li></ul></ul><ul><ul><ul><li>Determines the size of the interest payments </li></ul></ul></ul><ul><ul><li>K—the current market yield on comparable bonds </li></ul></ul><ul><ul><ul><li>The appropriate discount rate that makes the present value of the payments equal to the price of the bond in the market </li></ul></ul></ul><ul><ul><ul><ul><li>AKA yield to maturity (YTM) </li></ul></ul></ul></ul><ul><ul><li>Current yield—annual interest payment divided by bond’s current price </li></ul></ul>
  • 15. Solving Bond Problems with a Financial Calculator <ul><li>Financial calculators have five time value of money keys </li></ul><ul><li>With a bond problem, all five keys are used </li></ul><ul><ul><li>N—number of periods until maturity </li></ul></ul><ul><ul><li>I—market interest rate </li></ul></ul><ul><ul><li>PV—price of bond </li></ul></ul><ul><ul><li>FV—face value (par) of bond </li></ul></ul><ul><ul><li>PMT—coupon interest payment per period </li></ul></ul><ul><ul><ul><li>With calculators that have a sign convention the PMT and FV must be of one sign while the PV will be the other sign </li></ul></ul></ul><ul><li>The unknown will be either the interest rate or the present value </li></ul><ul><ul><li>When solving for the interest rate, the price of the bond must be inputted as a negative value while the PMT and FV must be inputted as a positive value </li></ul></ul><ul><li>Sophisticated calculators have a ‘bond’ mode allowing easy calculations dealing with accrued interest </li></ul>
  • 16. Determining the Price of a Bond—Example Q: The Emory Corporation issued an 8%, 25-year bond 15 years ago. At the time of issue it sold for its par (face) value of $1,000. Comparable bonds are yielding 10% today. What must Emory’s bond sell for in today’s market to yield 10% (YTM) to the buyer? Assume the bond pays interest semiannually. Also calculate the bond’s current yield. A: We need to solve for the present value of the bond’s expected cash flows at today’s interest rate. We’ll use Equation 6.4 to do so: Example K represents the periodic current market interest rate, or 10%  2. N represents the number of interest-paying periods until maturity, or 10 years x 2 = 20. The payment is 8% x $1,000, or $80 annually. However, it is received in the form of $40 every six months. The future value is the principal repayment of $1,000.
  • 17. Bond Example A: Substituting the correct values into the equation gives us: Example This is the price at which the bond must sell to yield 10%. It is selling at a discount because the current interest rate is above the coupon rate. The bond’s current yield is $80  $875.39, or 9.14%. This could also be calculated via a financial calculator: N PV PMT FV 20 -875.39 40 1000 5 I/Y Answer
  • 18. Maturity Risk Revisited <ul><li>Relates to term of the debt </li></ul><ul><ul><li>Longer term bonds fluctuate more in response to changes in interest rates than shorter term bonds </li></ul></ul><ul><li>AKA price risk and interest rate risk </li></ul><ul><li>As time passes, if interest rates don’t change the price of a bond will approach its par </li></ul>
  • 19. Table 6.1
  • 20. Maturity Risk Revisited
  • 21. Finding the Yield at a Given Price <ul><li>We’ve been calculating the intrinsic value of a bond, but we could calculate the bond yield (based on its current value in the market) and compare that yield to our required rate of return </li></ul>Involves solving for k, which is more complicated because it involves both an annuity and a FV Use trial and error to solve for k, or use a financial calculator.
  • 22. Finding the Yield at a Given Price—Example Example Q: The Benson Steel Company issued a 30-year bond 14 years ago with a face value of $1,000 and a coupon rate of 8%. The bond is currently selling for $718. What is the yield to an investor who buys it today at that price? (Assume semiannual interest.) A: Since the bond is now selling below par we can make an educated guess about the yield. As interest rates rise, bond prices fall, so the yield must be above 8%. Using a guess of 10% and applying Equation 6.4 we obtain: Clearly, 10% is not high enough. Recalculating the price of the bond at 14% gives us $620.56, which means that 14% is too high. The correct answer is 12%.
  • 23. Call Provisions <ul><li>If interest rates have dropped substantially since a bond was originally issued, a firm may wish to ‘refinance,’ or retire their old high interest bond issue </li></ul><ul><li>However, the issuing corporation would have to get all the bondholders to agree to this </li></ul><ul><ul><li>From the bondholder’s viewpoint, this could be a bad idea—they would be giving up high coupon bonds and would have to reinvest their cash in a market with lower interest rates </li></ul></ul><ul><li>To ensure that the corporation can refinance their bonds should they wish to do so, the corporation makes the bonds ‘callable’ </li></ul>
  • 24. Call Provisions <ul><li>Call provisions allow bond issuers to retire bonds before maturity by paying a premium (penalty) to bondholders </li></ul><ul><li>Many corporations offer a deferred call period (meaning the bond won’t be called for at least x years after the initial issuing date) </li></ul><ul><ul><li>Known as the call-protected period </li></ul></ul>
  • 25. Call Provisions <ul><li>The Effect of A Call Provision on Price </li></ul><ul><ul><li>When valuing a bond that is probably going to be called when the call-protected period is over </li></ul></ul><ul><ul><ul><li>Cannot use the traditional bond valuation procedure </li></ul></ul></ul><ul><ul><ul><ul><li>Cash flows will not be received through maturity because bond will probably be called </li></ul></ul></ul></ul>
  • 26. Figure 6.5: Valuation of a Bond Subject to Call
  • 27. Call Provisions <ul><li>Valuing the Sure-To-Be-Called Bond </li></ul><ul><ul><li>Requires that two changes be made to bond valuation formula </li></ul></ul>N now represents the number of periods until the bond is likely to be called. The future value becomes the call price (face value plus call premium).
  • 28. The Refunding Decision <ul><li>When current interest rates fall below the coupon rate on a bond, company has to decide whether or not to call in the issue </li></ul><ul><ul><li>Compare interest savings of issuing a new bond to the cost of making the call </li></ul></ul><ul><ul><ul><li>Calling in the bond requires the payment of a call premium </li></ul></ul></ul><ul><ul><ul><li>Issuing a new bond to raise cash to pay off the old bond requires payment of administrative expenses and flotation costs </li></ul></ul></ul>
  • 29. Dangerous Bonds with Surprising Calls <ul><li>Some bonds have contingency call features buried in the fine print </li></ul><ul><ul><li>For instance, some issuers would like to retire a portion of their bond issue periodically </li></ul></ul><ul><ul><ul><li>Versus paying a huge principal repayment on the entire issue at maturity </li></ul></ul></ul><ul><ul><li>This feature does not require a call provision </li></ul></ul><ul><ul><ul><li>Rather, those bondholders who must retire their bond are determined by lottery </li></ul></ul></ul>
  • 30. Risky Issues <ul><li>Sometimes bonds sell for a price far below what valuation techniques suggest </li></ul><ul><ul><li>Investors are worried that company may not be able to pay promised cash flows </li></ul></ul><ul><li>Valuation model should determine a price similar to the market price if the correct discount rate is used </li></ul><ul><ul><li>Riskier loans should be discounted at a higher interest rate leading to a lower calculated price </li></ul></ul>
  • 31. Convertible Bonds <ul><li>Unsecured bonds that are exchangeable for a fixed number of shares of the company’s stock at the bondholder's discretion </li></ul><ul><ul><li>Allows bondholders to participate in a stock’s price appreciation should the firm be successful </li></ul></ul><ul><li>Conversion ratio represents the number of shares of stock that will be received for each bond </li></ul><ul><li>Conversion price is the implied stock price if bond is converted into a certain number of shares </li></ul><ul><ul><li>Usually set 15-30% higher than the stock’s market value at the time the bond is issued </li></ul></ul><ul><li>Can usually be issued at lower coupon rates </li></ul>
  • 32. Convertible Bonds <ul><li>The effect of conversion on financial statements and cash flow </li></ul><ul><ul><li>Upon conversion an accounting entry removes the convertible bonds from long-term debt and places it into the equity accounts </li></ul></ul><ul><ul><li>There is no immediate cash flow impact, but ongoing cash flow implications exist </li></ul></ul><ul><ul><ul><li>Interest payments will stop </li></ul></ul></ul><ul><ul><ul><li>If the firm’s stock pays a dividend the newly created shares are entitled to those dividends </li></ul></ul></ul><ul><ul><li>Improves debt management ratios </li></ul></ul>
  • 33. Advantages of Convertible Bonds <ul><li>To issuing companies </li></ul><ul><ul><li>Convertible features are sweeteners that let the firm pay a lower interest rate (coupon) </li></ul></ul><ul><ul><li>Can be viewed as a way to sell equity at a price above market </li></ul></ul><ul><ul><li>Convertible bonds usually have few or no restrictions </li></ul></ul><ul><li>To buyers </li></ul><ul><ul><li>Offer the chance to participate in stock price appreciation </li></ul></ul><ul><ul><li>Offer a way to limit risk associated with a stock investment </li></ul></ul>
  • 34. Forced Conversion <ul><li>A firm may want its bonds to be converted because </li></ul><ul><ul><li>Eliminates interest payments on bond </li></ul></ul><ul><ul><li>Strengthens balance sheet </li></ul></ul><ul><li>Convertible bonds are always issued with call features which can be used to force conversion </li></ul><ul><li>Issuers generally call convertibles when stock prices rise to 10-15% above conversion prices </li></ul><ul><ul><li>Rational investors will convert if the conversion value is greater than the call value </li></ul></ul>
  • 35. Valuation (Pricing) Convertibles <ul><li>A convertible’s price can depend on </li></ul><ul><ul><li>Its value as a traditional bond or </li></ul></ul><ul><ul><li>The market value of the stock into which it can be converted </li></ul></ul><ul><li>At any stock price the convertible is worth at least the larger of its value as a bond or as stock </li></ul><ul><ul><li>The market value will be greater due to the possibility that the stock’s price will rise </li></ul></ul>
  • 36. Figure 6.7: Value of a Convertible Bond
  • 37. Effect on Earnings Per Share—Diluted EPS <ul><li>Upon conversion convertible bonds cause dilution in EPS </li></ul><ul><ul><li>EPS drops due to the increase in the number of shares of stock </li></ul></ul><ul><li>Thus convertible bonds have the potential to dilute EPS </li></ul><ul><ul><li>Therefore convertible bonds will impact the calculation of Diluted EPS according to FASB 128 </li></ul></ul>
  • 38. Effect on Earnings Per Share—Diluted EPS—Example Example Q: Montgomery Inc. is a small manufacturer of men’s clothing with operations in Southern California. It issued 2,000 convertible bonds in 1999 at a coupon rate of 8% and a par value of $1,000. Each bond is convertible into Montgomery’s common stock at $40 per share. Management expected the stock price to rise rapidly after the convertible was issued and lead to a quick conversion of the bond debt into equity. However, a recessionary climate has prevented that from happening, and the bonds are still outstanding. In 2003 Montgomery had net income of $3 million. One million shares of its stock were outstanding for the entire year, and its marginal tax rate is 40%. Calculate Montgomery’s basic and diluted EPS. A: Basic EPS is the firm’s net income divided by the number of shares outstanding, or $3,000,000 ÷ 1,000,000 = $3.00.
  • 39. Effect on Earnings Per Share—Diluted EPS—Example Example <ul><li>Diluted EPS assumes all convertible bonds are converted at the beginning of the year. Two adjustments need to be made: </li></ul><ul><ul><li>Add the number of newly converted shares to the denominator: </li></ul></ul><ul><ul><ul><li>Shares exchanged: Bond’s par ÷ Conversion price = $1,000 ÷ $25 = 40 </li></ul></ul></ul><ul><ul><ul><ul><li>Since each bond can be converted into 40 shares of stock and there are 2,000 bonds, the newly converted shares totals 80,000, or 40 x 2,000, bringing the total number of shares outstanding to 1,080,000. </li></ul></ul></ul></ul>
  • 40. Effect on Earnings Per Share—Diluted EPS—Example <ul><ul><li>Adjust the net income figure in the numerator by the amount of interest saved: </li></ul></ul><ul><ul><ul><li>The 2,000 bonds pay 8% interest on a $1,000 par; therefore the first will save $160,000 in interest, or .08 x $1,000 x 2,000. </li></ul></ul></ul><ul><ul><ul><li>However, the interest expense was tax deductible, so the firm’s taxable income will now rise by $160,000, resulting in an increase in taxes of $64,000, or $160,000 x 40%. </li></ul></ul></ul><ul><ul><ul><li>Thus the firm’s Net Income will rise by $96,000 resulting in a new Net Income of $3,096,000. </li></ul></ul></ul><ul><li>The firm’s Diluted EPS will be: $3,096,000 ÷ 1,080,000 = $2.87. </li></ul>Example
  • 41. Institutional Characteristics of Bonds <ul><li>Registration, Transfer Agents, and Owners of Record </li></ul><ul><ul><li>A record of registered securities is kept by a transfer agent </li></ul></ul><ul><ul><li>Payments are sent to owners of record as the dates as of the dates the payments are made </li></ul></ul><ul><li>Bearer bonds vs. registered bonds </li></ul><ul><ul><li>Bearer bonds—interest payment is made to the bearer of the bond </li></ul></ul><ul><ul><li>Registered bonds—interest payment is made to the holder of record </li></ul></ul>
  • 42. Kinds of Bonds <ul><li>Secured bonds and mortgage bonds </li></ul><ul><ul><li>Backed by collateral </li></ul></ul><ul><li>Debentures </li></ul><ul><ul><li>Unsecured bonds </li></ul></ul><ul><li>Subordinated debentures </li></ul><ul><ul><li>Lower in priority than senior debt </li></ul></ul><ul><li>Junk bonds </li></ul><ul><ul><li>Issued by risky companies and pay high interest rates </li></ul></ul>
  • 43. Bond Ratings—Assessing Default Risk <ul><li>Bond rating agencies (such as Moody’s, S&P) evaluate bonds (and issuing firms) and assign a rating to each bond issued by a corporation </li></ul><ul><li>These ratings gauge the probability that issuers will fail to meet their obligations </li></ul>
  • 44. Bond Ratings—Assessing Default Risk <ul><li>Why Ratings Are Important </li></ul><ul><ul><li>Ratings are the primary measure of the default risk associated with bonds </li></ul></ul><ul><ul><li>Thus, ratings play a big part in the interest rate that investors demand </li></ul></ul><ul><ul><ul><li>The rating a firm’s bonds receive basically determines the rate at which the firm can borrow </li></ul></ul></ul><ul><ul><ul><ul><li>A lower quality rating implies a higher borrowing rate </li></ul></ul></ul></ul>
  • 45. Bond Ratings—Assessing Default Risk <ul><li>The differential between the yields on high and low quality bonds is an indicators of the health of the economy </li></ul><ul><li>The Differential Over Time </li></ul><ul><ul><li>The quality differential tends to be larger when interest rates are generally high </li></ul></ul><ul><ul><ul><li>May indicate a recession and marginal firms are more likely to fail, making them riskier </li></ul></ul></ul><ul><li>The Significance of the Investment Grade Rating </li></ul><ul><ul><li>Many institutional investors are prohibited from trading below-investment-grade bonds </li></ul></ul>
  • 46. Table 6.2
  • 47. Bond Indentures—Controlling Default Risk <ul><li>As a bondholder, you would like to ensure that you will receive your promised interest and principal payments </li></ul><ul><ul><li>Bond indentures attempt to prevent firms from becoming riskier after the bonds are purchased, and includes such protective covenants as: </li></ul></ul><ul><ul><ul><li>Limits to management’s salary </li></ul></ul></ul><ul><ul><ul><li>Limits to dividends </li></ul></ul></ul><ul><ul><ul><li>Maintenance of certain financial ratios </li></ul></ul></ul><ul><ul><ul><li>Restrictions on additional debt issues </li></ul></ul></ul><ul><ul><li>Sinking funds provide money for the repayment of bond principal </li></ul></ul>
  • 48. Appendix 6-A: Lease Financing <ul><li>A lease is a contract giving one party (lessee) the right to use an asset owned by another (lessor) for a periodic payment </li></ul><ul><ul><li>Individuals may lease houses, apartments and automobiles </li></ul></ul><ul><ul><li>Corporations may lease equipment and real estate </li></ul></ul><ul><ul><ul><li>Approximately 30% of all equipment today is leased </li></ul></ul></ul>
  • 49. Appendix 6-A: Leasing and Financial Statements <ul><li>Originally leasing allowed the lessee to use the asset without ownership </li></ul><ul><ul><li>Lease payments were recognized as expenses on the income statement </li></ul></ul><ul><ul><li>Had no impact on balance sheet </li></ul></ul><ul><li>Led to large use of lease financing </li></ul><ul><ul><li>Became the leading form of off balance sheet financing </li></ul></ul>
  • 50. Appendix 6-A: Misleading Results <ul><li>Off balance sheet financing makes financial statements misleading </li></ul><ul><ul><li>Missed lease payments can cause the firm to fail just like a missed interest payment on debt </li></ul></ul><ul><ul><li>Thus long-term leases are effectively the same as debt </li></ul></ul><ul><ul><li>Not having leases appear on the balance sheet can mislead investors to think a firm is stronger than it is </li></ul></ul>
  • 51. Appendix 6-A: Misleading Results <ul><li>By the early 1970s concerns led to FASB 13 </li></ul><ul><ul><li>Prior to FASB 13 an asset was owned by whoever held its title regardless of who used the asset </li></ul></ul><ul><ul><li>FASB 13 stated that the real owner of an asset is whoever enjoys its benefits and deals with the risks and responsibilities </li></ul></ul>
  • 52. Appendix 6-A: Operating and Capital (Financing) Leases <ul><li>Under FASB 13 lessees must capitalize financing leases </li></ul><ul><ul><li>Puts the value of leased assets and liabilities on the balance sheet </li></ul></ul><ul><ul><ul><li>Makes the balance sheet similar to what it would have been had the asset been purchased with borrowed money </li></ul></ul></ul><ul><li>Operating leases can still be listed off the balance sheet </li></ul>
  • 53. Appendix 6-A: Operating and Capital (Financing) Leases <ul><li>Rules that must be met for a lease to be classified as an operating lease </li></ul><ul><ul><li>Lease must not transfer legal ownership to the lessee at its end </li></ul></ul><ul><ul><li>Must not be a bargain purchase option at the end of the lease </li></ul></ul><ul><ul><li>Lease term must be < 75% of the asset’s estimated economic life </li></ul></ul><ul><ul><li>Present value of the lease payments must be < 90% of the asset’s fair market value at the beginning of the lease </li></ul></ul>
  • 54. Appendix 6-A: Financial Statement Presentation of Leases by Lessees <ul><li>Operating leases </li></ul><ul><ul><li>No balance sheet entries </li></ul></ul><ul><ul><li>Lease payments are treated as an expense </li></ul></ul><ul><ul><li>Details must be listed in footnotes </li></ul></ul><ul><li>Financing leases </li></ul><ul><ul><li>Lessee must record an asset on balance sheet </li></ul></ul><ul><ul><li>Lessee must record an offsetting liability </li></ul></ul><ul><ul><ul><li>Both of the above amounts are usually the present value of the stream of committed lease payments </li></ul></ul></ul><ul><ul><ul><li>The interest rate is generally the rate the lessee would pay if it were borrowing money at the time the lease begins </li></ul></ul></ul><ul><ul><li>The asset is depreciated while the Lease Obligation is treated like a loan </li></ul></ul>
  • 55. Appendix 6-A: Leasing from the Perspective of the Lessor <ul><li>Lessors are usually banks, finance companies and insurance companies </li></ul><ul><ul><li>Companies buy the equipment and lease it to customer </li></ul></ul><ul><li>Lease payments are calculated to offer the lessor a given return </li></ul><ul><ul><li>The interest rate is called the lessor’s return or the rate implicit in the lease </li></ul></ul><ul><li>Lessor holds legal title—can repossess assets if lessee defaults </li></ul><ul><li>Lessors get better treatment in bankruptcy proceedings than lenders </li></ul>
  • 56. Appendix 6-A: Residual Values <ul><li>Residual value—the value of an asset at the end of the lease term </li></ul><ul><ul><li>Lessee may buy the equipment </li></ul></ul><ul><ul><li>Lessor may sell it to someone else </li></ul></ul><ul><ul><li>Asset may be re-leased (usually only with operating leases) </li></ul></ul><ul><li>Makes lease pricing and return calculations more complex </li></ul><ul><li>Often are important negotiating points between lessee and lessor </li></ul>
  • 57. Appendix 6-A: Lease Vs. Buy—The Lessee’s Perspective <ul><li>Broad financing possibilities </li></ul><ul><ul><li>Equity </li></ul></ul><ul><ul><li>Debt—available through bonds or banks </li></ul></ul><ul><ul><li>Leasing—available through leasing companies </li></ul></ul><ul><li>Should conduct a lease vs. buy comparison </li></ul><ul><ul><li>Choose the lowest cost in a present value sense </li></ul></ul>
  • 58. Appendix 6-A: The Advantages of Leasing <ul><li>No money down </li></ul><ul><ul><li>Lenders typically require some downpayment; whereas lessors usually do not </li></ul></ul><ul><li>Restrictions </li></ul><ul><ul><li>Lenders usually require covenants/indentures, whereas lessors have few, if any, restrictions </li></ul></ul><ul><li>Easier credit with manufacturers/lessors </li></ul><ul><ul><li>Equipment manufacturers sometimes lease their own products and will lease to marginally creditworthy customers </li></ul></ul>
  • 59. Appendix 6-A: The Advantages of Leasing <ul><li>Avoiding the risk obsolescence </li></ul><ul><ul><li>Short leases transfer this risk to lessors </li></ul></ul><ul><li>Tax deducting the cost of land </li></ul><ul><ul><li>If real estate is leased the lease payment can be deducted as an expense, whereas if the land is owned it is not depreciable </li></ul></ul><ul><li>Increasing liquidity—the sale and leaseback </li></ul><ul><ul><li>A firm may sale an asset (to generate cash) and lease the same asset back—used to free up cash invested in real estate </li></ul></ul><ul><li>Tax advantages for marginally profitable companies </li></ul>
  • 60. Appendix 6-A: Leveraged Leases <ul><li>The ability to depreciate an asset reduces taxes </li></ul><ul><li>If a company is not making a profit (and not paying taxes) then depreciation is not saving the firm any money </li></ul><ul><li>A lessor buys equipment but finances a portion of the price of the equipment (hence, the term leveraged) and is allowed to depreciate the leased assets and gain the tax benefits </li></ul><ul><li>The lessor passes along some of the benefits to the lessee in the form of lower lease payments </li></ul>

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