Chapter 16: Long-Term Debt and Lease Financing
16-1
Chapter 16
Long-Term Debt and Lease Financing
Discussion Questions
16-1.
Corporate debt has been expanding very dramatically in the last three decades.
What has been the impact on interest coverage, particularly since 1977?
In 1977, the average U.S. manufacturing corporation had its interest covered
almost eight times. By the 2000’s, the ratio had been cut to less than half.
16-2.
What are some specific features of bond agreements?
The bond agreement specifies such basic items as the par value, the coupon
rate, and the maturity date.
16-3.
What is the difference between a bond agreement and a bond indenture?
The bond agreement covers a limited number of items, whereas the bond
indenture is a supplement that often contains over 100 pages of complicated
legal wording and specifies every minute detail concerning the bond issue. The
bond indenture covers such topics as pledged collateral, methods of repayment,
restrictions on the corporation, and procedures for initiating claims against the
corporation.
16-4.
Discuss the relationship between the coupon rate (original interest rate at time
of issue) on a bond and its security provisions.
The greater the security provisions afforded to a given class of bondholders, the
lower the coupon rate.
Chapter 16: Long-Term Debt and Lease Financing
16-5.
Take the following list of securities and arrange them in order of their priority
of claims:
Preferred stock Senior debenture
Subordinated debenture Senior secured debt
Common stock Junior secured debt
The priority of claims can be determined from Figure 16-2:
senior secured debt,
junior secured debt,
senior debenture,
subordinated debenture,
preferred stock,
common stock.
16-6.
What method of “bond repayment” reduces debt and increases the amount of
common stock outstanding?
Conversion of bonds to common stock through either a convertible bond or an
exchange offer.
16-7.
What is the purpose of serial repayments and sinking funds?
The purpose of serial and sinking fund payments is to provide an orderly
procedure for the retirement of a debt obligation. To the extend bonds are paid
off over their life, there is less risk to the security holder.
16-8.
Under what circumstances would a call on a bond be exercised by a
corporation? What is the purpose of a deferred call?
A call provision may be exercised when interest rates on new securities are
considerably lower than those on previously issued debt. The purpose of a
deferred call is to insure that the bondholder will not have to surrender the
security due to a call for at least the first five or ten years.
Chapter 16: Long-Term Debt and Lease Financing
16-9.
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?
Bond prices on outstanding issues and market interest rates move in
opposite directions. If interest rates go up, bond prices will go down and
vice versa. Long-term bonds are particularly sensitive to interest rate
changes because the bondholder is locked into the interest rate for an
extended period of time.
16-10.
What is the difference between the following yields: coupon rate, current yield,
yield to maturity?
The different bond yield terms may be defined as follows:
Coupon rate – stated interest rate divided by par value.
Current yield – stated interest rate divided by the current price of the bond.
Yield to maturity – the interest rate that will equate future interest payments
and payment at maturity to a current market price.
16-11.
How does the bond rating affect the interest rate paid by a corporation on
its bonds?
The higher the rating on a bond, the lower the interest payment that will be
required to satisfy the bondholder.
16-12.
Bonds of different risk classes will have a spread between their interest
rates. Is this spread always the same? Why?
The spread in the yield between bonds in different risk classes is not
always the same. The yield spread changes with the economy. If investors
are pessimistic about the economy, they will accept as much as 3% less
return to go into very high-quality securities-whereas, in more normal
times the spread may only be 1 ½%.
16-13.
Explain how the bond refunding problem is similar to a capital budgeting
decision.
The bond refunding problem is similar to a capital budgeting problem in
that an initial investment must be made in the form of redemption and
reissuing costs, and cash inflows will take place in the form of interest
savings. We take the present value of the inflows to determine if they
equal or exceed the outflow.
Chapter 16: Long-Term Debt and Lease Financing
16-14.
What cost of capital is generally used in evaluating a bond refunding
decision? Why?
We use the aftertax cost of new debt as the discount rate rather than the
more generalized cost of capital. Because the net cash benefits are known
with certainty, the refunding decision represents a riskless investment. For
this reason, we use a lower discount rate.
16-15.
Explain how the zero-coupon rate bond provides return to the investor.
What are the advantages to the corporation?
The zero-coupon-rate bond is initially sold at a deep discount from par
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. The
advantages to the corporation are that there is immediate cash inflow to the
corporation, without any outflow until the bond matures. Furthermore, the
difference between the initial bond price and the maturity value may be
amortized for tax purposes over the life of the bond by the corporation.
16-16.
Explain how floating rate bonds can save the investor from potential
embarrassments in portfolio valuations.
Interest payments change with changing interest rates rather than with the
market value of the bond. This means that the market value of a floating
rate bond is almost fixed. The one exception is when interest rates dictated
by the floating rate formula approach (or exceed) broadly defined limits.
16-17.
Discuss the advantages and disadvantages of debt.
The primary advantages of debt are:
a. Interest payments are tax deductible.
b. The financial obligation is clearly specified and of a fixed nature.
c. In an inflationary economy, debt may be paid back with cheaper
dollars (the dollars have less purchasing power than when received).
d. The use of debt, up to a prudent point, may lower the cost of capital to
the firm.
Chapter 16: Long-Term Debt and Lease Financing
16-18.
What is a Eurobond?
A Eurobond is a bond payable in the borrower’s currency but sold outside
the borrower’s country. It is usually sold by an international syndicate.
16-19.
What do we mean by capitalizing lease payments?
Capitalizing lease payments means computing the present value of future
lease payments and showing them as an asset and liability on the balance
sheet.
16-20.
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.
In both cases we create an asset and liability on the balance sheet.
Furthermore in both cases, for income statement purposes, we amortize the
asset and write off interest (implied or actual) on the debt.
Appendix
16A-1.
What is the difference between technical insolvency and bankruptcy?
Technical insolvency refers to the circumstances where a firm is unable to pay its bills
as they come due. A firm may be technically insolvent even though it has a positive net
worth. Bankruptcy, on the other hand, indicates that the market value of a firm’s assets
is 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.
Chapter 16: Long-Term Debt and Lease Financing
16A-2.
What are the four types of out-of-court settlements? Briefly describe each.
Extension – Creditors agree to allow the firm more time to meet its
financial obligations.
Composition – Creditors agree to accept a fractional settlement on their
original claims.
Creditor committee – A creditor committee is set up to run the business because it is
believed that management can no longer conduct the affairs of
the firm.
Assignment – Liquidation of assets takes place without going through formal
court action.
16A-3.
What is the difference between an internal reorganization and an external
reorganization under formal bankruptcy procedures?
An internal reorganization calls for an evaluation and restricting of the current affairs
of the firm. Current management may be replaced and a redesign of the capital
structure may be necessary. An external reorganization means that an actual merger
partner will be found for the firm.
16A-4.
What are the first three priority items under liquidation in bankruptcy?
(1) Cost of administering the bankruptcy procedures.
(2) Wages due workers if earned within three months of filing the bankruptcy
petition. The maximum amount is $600 per worker.
(3) Tax due at the federal, state or local level.
Chapter 16: Long-Term Debt and Lease Financing
Chapter 16
Problems
(Assume the par value of the bonds in the following problems is $1,000 unless otherwise
specified.)
1. Bond yields (LO2) Garland Corporation has a bond outstanding with a $90 annual interest
payment, a market price of $820, and a maturity date in five years. Find the following:
a. The coupon rate.
b. The current rate.
c. The approximate yield to maturity.
16–1. Solution:
Garland Corporation
a. $90 interest/$1,000 par = 9% coupon rate
c. Approximate yield to maturity = (Y’)
payment) (Principal .4bond) theof (Price .6
maturity toyears ofNumber
bond theof Pricepayment Principal
paymentinterest Annual
)Y’(+
−
+
=
Chapter 16: Long-Term Debt and Lease Financing
2. Bond yields (LO2) Preston Corporation has a bond outstanding with a $110 annual interest
payment, a market price of $1,200, and a maturity date in 10 years.
Find the following:
a. The coupon rate.
b. The current rate.
c. The approximate yield to maturity.
16–2. Solution:
Preston Corporation
a. $110 interest/$1,000 par = 11% coupon rate
b. $110 interest/$1,200 market price = 9.17% current yield
c. Approximate yield to maturity = (Y’)
payment) (Principal .4bond) theof (Price .6
maturity toyears ofNumber
bond theof Pricepayment Principal
paymentinterest Annual
)Y’(+
−
+
=
$1,000 $1,200
$110 10
.6($1,200) .4($1,000)
$200
$110 10
$720 $400
$110 $20
−
+
=
+
−
+
=
+
−
=
Chapter 16: Long-Term Debt and Lease Financing
16-9
3. Bond yields (LO2) An investor must choose between two bonds:
Bond A pays $80 annual interest and has a market value of $800. It has 10 years to
maturity.
Bond B pays $85 annual interest and has a market value of $900. 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 approximate yield to maturity on Bond A is 11.36 percent. What is the
approximate 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?
16–3. Solution:
a. Bond A
$80 interest/$800 market price = 10% current yield
Bond B
$85 interest/$900 market price = 9.44% current yield
payment) (Principal .4bond) theof (Price .6
maturity toyears ofNumber
bond theof Pricepayment Principal
paymentinterest Annual
)Y’(+
−
+
=
Chapter 16: Long-Term Debt and Lease Financing
16–3. (Continued)
$1,000 $900
$85 2
.6($900) .4($1,000)
$100
$85 2
($540 $400)
$85 $50
$940
$135 14.36%
$940
−
+
=
+
+
=
+
+
=
==
recovery period.
4. Bond yields (LO2) An investor must choose between two bonds:
Bond A pays $92 annual interest and has a market value of $875. It has 10 years to
maturity. Bond B pays $82 annual interest and has a market value of $900. It has two years
to maturity.
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