Download Chapter F4

CHAPTER F4
The Balance Sheet
(Continued): Additional
Financing – Borrowing
From Others
© 2007 Pearson Custom Publishing
1
Financing Sources
 Internal Financing
 Over the long run, successful companies
are “financed” by their profits from
operations.
 External Financing
 Funding from outside sources is often
necessary during start-up phase, during
times of expansion, and during temporary
economic downturns for the business.
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External Financing Sources
 The two major sources of external
financing are:
 (1) Equity Financing: exchanging an
ownership interest in the business for
funds, such as selling stock by a
corporation.
 (2) Debt Financing: borrowing funds
from any of several different sources, no
ownership interest is given up.
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Length of Financing Term
 Short-term Financing is needed for day-
to-day operations. We will define shortterm debt as any financing that must be
paid back within five years.
 Long-term Financing is needed to
achieve the long-term goals of the
business. We will consider it to be longterm debt if repayment is delayed for over
five years.
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Learning Objective 1:
Describe how banks earn
profits.
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Borrowing from Financial
Institutions
 When individuals obtain loans for
personal uses (cars, etc.), it is
known as consumer borrowing.
 When a business obtains a loan it is
known as commercial borrowing.
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Borrowing from Financial
Institutions
 Most of the major banks are known
as commercial banks because they
make a great deal of loans to
businesses. Most Credit Unions
and Savings and Loans do not
make commercial loans.
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Interest
 Interest represents rent paid to use
borrowed money (the cost of
borrowing).
 Banks make a profit primarily by
paying out low rates of interest to
customers for their deposits, while
charging the customers higher
rates of interests on loans.
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How Banks Earn Profits
 Banks charge interest on loans to
customers:
 Interest charged ($10,000 x 9%)
 Interest paid ($10,000 x 4%)
 Bank gross profit
$900
400
$500
 Two major complications:
 1. Loans may not be paid back (loan default).
 2. Customers might remove the cash from their
deposit accounts.
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Learning Objective 2:
Explain the effects on a
company’s balance sheet
when funds are
borrowed from a bank.
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Notes Payable Example
 Assume that Your Company signs a
$10,000, 8%, 5-year note payable at the
local commercial bank. Interest has to
be paid at the end of each year, and the
principal amount must be repaid at the
end of the term.
 ASSETS = LIABILITIES + EQUITY
 $10,000 =
$10,000
+ $0
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Notes Payable Example
This would be the balance sheet impact at the
time of the loan, no interest has yet accrued.
Your Company
Balance Sheet
January 3, 1999
Assets
Cash
Liabilities
$20,000
Note payable
$10,000
Owners' equity
You, Capital
Total assets
$20,000
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Total L & OE
$10,000
$20,000
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Learning Objective 3:
Distinguish among notes,
mortgages, and bonds.
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Notes Payable
 A note payable is another name for a loan
made between two entities.
 Sometimes, a business may have to offer
collateral in order to secure the note. The
collateral (specific assets) will be forfeited
if the loan goes into default.
 A mortgage on real estate (land and/or
buildings) is a long-term collateral loan.
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Bonds Payable
 A bond payable is a type of note
payable usually borrowed for a long
period of time and sold to investors in
the financial markets.
 Bonds may have collateral, but many
do not. A bond without collateral is a
debenture bond.
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Learning Objective 4:
Calculate interest
payments for notes and
bonds.
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Calculating Interest
 Interest on a note payable would be
calculated as follows:
 Principal X Rate = Annual Interest
 $10,000 X 8% = $800
 Calculations differ slightly if for < 1 year:
 Principal X Rate X Time = Interest
 $10,000 X
8% X 3/12 = $200 (3 mos.)
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Interest Examples
 Calculate the monthly interest on a
$100,000 loan, paying 9% annual
interest.
$100,000 X 9% X 1/12 = $750
 Calculate the semi-annual interest on a
$1 Million, 7.5% bond.
$1,000,000 X 7.5% X 6/12 = $37,500
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Discussion Questions
 In the example of a $100,000 bank loan, what
was the lender’s return on investment. What
was their return of investment?
 Why does the local bank pay a higher rate of
interest on long-term certificate of deposits
(CDs) than they do on shorter-term CDs?
 Why does the local bank charge a lower rate of
interest on mortgage debt than they do on
credit card debt?
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Computing Due Dates
 A two-month note issued on January 10
is due on March 10.
 A 60-day note issued on January 10 is
due on March 11.
 January
 February
 March
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21 days
28 days
11 days
60 days
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Effective Interest Rate
The rate of interest actually
earned by a lender
 If P X R = I, then R = I ÷P
 Discounted notes have higher
effective rate than the stated
interest rate.
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Discounted Notes
 Smith borrows $10,000 at 10% from
the bank for a year on a discounted
basis. Compute the effective rate.
R = I ÷P = $1,000 ÷ $9,000 = 11.11%
 What if the note was for only 3
months?
R = I ÷P x 12/3 = $250 ÷ $9,750 x 12/3
= 10.26%
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Learning Objective 5:
Explain the functions of
underwriters in the
process of issuing bonds.
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Discussion Question
 Assume that you own a company that has
$100 million in total assets and annual
sales of $200 million. You decide that you
need an additional $20 million to undertake
an ambitious expansion program.
 Do you think that the local commercial
bank would have the ability to loan you
that amount of money?
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The Role of Underwriters
 When the amount of a bond issue is very
large, a group of underwriters will form a
syndicate to sell the large bond issue.
 Underwriters are intermediary investment
bankers who buy the issues and sell them
to interested investors.
 Underwriters make money by charging
about one percent of the issue price.
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Learning Objective 6:
Describe the effect of
market interest rates on
bond selling prices.
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Bonds
 Corporate bonds are a form of interest-
bearing long-term debt that a corporation
could use to borrow large amounts of
funds.
 Borrowing through notes payable is usually
limited because most commercial banks
cannot make extremely large loans for a
very long period of time.
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Bond Terminology
 The bond indenture is a legal document
that specifies all of the details of the
bond issuance.
 The par value (also called face value) is
the stated amount that the corporation
will pay back to the bondholder at the
end of the term. Most corporate bonds
have a par value of $1,000.
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Bond Terminology
 The selling price (also called issue
price or market price) of the bonds is
usually stated as a percentage of the
bond par value.
 For example: if a bond price is
quoted at “95,” that means it is
selling at 95% of face value, or $950.
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Bond Terminology
 The bond indenture will specify a
nominal interest rate (also called the
contract rate, coupon rate, or stated
rate). The nominal rate is multiplied
by the bond par value to determine
the interest payments made to the
bondholders.
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Bond Interest Example
 Interest Example: A $1,000 twenty-
year bond has a stated interest rate
of 8%, interest payable
semiannually.
 Every six months for twenty years,
the bondholder will receive interest
equal to
$1,000 X 8% X 6/12 = $40
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Bond Terminology
 Whereas the nominal interest rate
does not change over the life of
the bonds, the effective interest
rate for any given bond issue can
fluctuate on a daily basis.
 The effective rate is also called
market rate or yield rate of
interest.
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Bond Terminology
 The effective interest rate is determined
by the bond market. If the bond price
goes up, the effective interest rate goes
down, and vice versa.
 However, once you buy a bond, you
have “locked-in” that effective rate of
interest for as long as you hold the
bond.
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Issuing Bonds at Par
 Your Company so far has $20,000 cash to get
started with. You feel that you need about $20,000
more and decide to issue ten-year, 8% bonds.
Let’s assume that the bond market feels that 8% is
an appropriate rate for the level of risk associated
with your corporate bonds, and the 20 bonds are
issued at par, or $1,000 each.
 NOTE: Brand new companies rarely issue bonds and
when bonds are issued, they are usually used to acquire
millions of dollars in financing, not thousands.
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Issuing Bonds at Par
 ASSETS = LIABILITIES + EQUITY
 $20,000 =
$20,000
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+
$0
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Issuing Bonds at Par
 ASSETS = LIABILITIES + EQUITY
 $20,000 =
$20,000
+
$0
You r Com pan y
Balan ce Sheet
Janu ary 5, 1999
Assets
Cash
T otal assets
$40,000
$40,000
© 2007 Pearson Custom Publishing
Liabilities
No te p ayable $10,000
Bon ds p ayable 20,000 $30,000
O wners' eq u ity
Yo u, Cap ital
10,000
To tal L & OE
$40,000
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Issuing Bonds at Par
 Notice that on the balance sheet, Your
Company now has two liabilities: (1) the
note payable to the bank for $10,000, and (2)
the bonds payable of $20,000.
 Only the principal amounts show up as
liabilities at this time. Interest is only
starting to accrue on these debts, so there
is no interest liability to be recorded yet.
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Discounts and Premiums
 Bond prices are influenced by many
things. A bond might sell for par value as
previously illustrated, but they usually sell
at a discount or for a premium.
 If a bond sells for less than par value, it is
being sold at a discount. If a bond sells for
more than par value, it is being sold for a
premium.
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Learning Objective 7:
Contrast the operations of
the primary and
secondary bond markets.
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Primary Bond Market
 Investment bankers and banking
syndicates typically act as
underwriters and handle the initial
issuance of bonds by a corporation.
The underwriters will buy all of the new
bonds from a company, then resell
them to investors at a higher price.
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Primary Bond Market
 The underwriters also help prepare the
prospectus for the bonds. The prospectus
provides details about the bonds and about
the company issuing them.
 In the prospectus you learn about the
overall condition of the company, their
future prospects (very speculative), and
other information that is helpful for deciding
whether you want to invest in the bonds.
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Secondary Bond Market
 Once bonds have been issued by a
corporation, those bonds can be freely bought
and sold in the secondary bond market. The
issuing corporation is basically unaffected by
these subsequent sales between investors.
 After the initial issuance, the company’s
involvement is limited to paying interest on the
due dates and paying off the principal at the
end of the bond term.
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Reading the Bonds Listings
Cur
Yld.
Vol.
Close
Net
Chg.
ATT 5.125s09
5.2
194
99.38
-0.5
ATT 7.125s12
6.9
600
104.3
-0.25
ATT 8.125s22
7.6
328
107.3
-0.75
BurNo 3.2s45
6.4
25
50
-2.5
NoPac 3s47
6.9
1
43.38
---
Motrla zr13
…
122
90
+6
HewlPkd zr17
…
40
56.5
---
HomeDpt 3.25s20
cv
10
264
-10.25
Bonds
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Reading the Bonds Listings
 Three different AT&T bond issues are
shown. The first number listed is the
nominal interest rate; 5.125%, 7.125%,
8.125%.
 The next number is a two-digit designation
of the year that the bonds mature; 2009,
2012, 2022. (NOTE: The “s” is simply a
separator between the interest rate and the
date.)
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Reading the Bonds Listings
 The “Cur Yld.” is the effective interest
rate (or current yield rate).
 The “Vol.” column shows the number of
$1,000 bonds sold the previous day.
 “Close” shows the final selling price of
the day, expressed as a % of par value,
such as 99.375% of $1,000 par value.
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Reading the Bonds Listings
 The BurNo bonds sell for $500 (50% of
$1,000). This discount is needed because the
bonds have a stated interest rate of 3.2%, but
bond investors want a rate of 6.4% on bonds
at this level of risk. Are the NoPac bonds
more risky or less?
 Why would BurNo and NoPac issue bonds
that pay such a low rate of interest?
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Reading the Bonds Listings
 The Motrla and HewlPkd bonds are zero
coupon bonds, meaning that no interest
payments are made, just the face value
is repaid at the end of the term.
 Buy a HewlPkd bond for $565 and you
will get back $1,000 when they mature
in 2017 (hopefully!).
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Reading the Bonds Listings
 The HomeDpt bonds are convertible bonds,
which means they can be exchanged for
(converted into) company stock.
 It should be obvious by now that an investor
would not pay $2,640 to buy a $1,000 bond
that only pays 3.25% interest. The investor
is actually buying the “right” to convert that
bond into a specified number of common
shares of HomeDpt stock.
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Discussion Question
 Think about the effects of
premiums on the effective interest
rate. What annual effective
interest rate is an investor earning
on a $1,000 bond that pays 12.5%
interest if she pays 105 to buy it?
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Learning Objective 8:
Compare and contrast two
investment alternatives—
equity investment and debt
investment.
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Comparing Debt with
Equity - Investments
 On pages F-112 through F-116, there is a
thorough example of the choices that an
investor would face if choosing between an
equity investment (buying stock) and a debt
investment (buying bonds).
 The focus is on the three questions: (1) Will
I be paid? (2) When will I be paid? (3) How
much will I be paid?
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Comparing Debt with
Equity - Financing
 Let’s shift the focus away from someone who
is planning to buy the stocks or bonds, to a
company that is in need of additional
financing and has to choose whether to issue
stock (equity) or bonds (debt).
 Let’s assume that the company wants to
acquire approximately $20,000,000 cash, and
their balance sheet looks like this prior to
acquiring the additional financing:
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Before Additional Financing
Mega Corporation
Balance Sheet
January 31, 1999
(Dollars in thousands)
Assets
Cash
Other assets
Total assets
$2,000
38,000
$40,000
Liabilities
Note payable
$1,000
Other liabilities
14,000
Bonds payable
5,000 $20,000
Owners' equity
Common stock 15,000
Retained earnings 5,000 20,000
Total L & OE
$40,000
Assume Mega wants the extra $20 million
for expansion purposes.
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With Debt Financing
Mega Corporation
Balance Sheet
January 31, 1999
(Dollars in thousands)
Assets
Cash
Other assets
Total assets
$22,000
38,000
$60,000
Liabilities
Note payable
$1,000
Other liabilities
14,000
Bonds payable 25,000 $40,000
Owners' equity
Common stock 15,000
Retained earnings 5,000 20,000
Total L & OE
$60,000
Notice that $20 million has been added to both
cash and bonds payable.
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With Equity Financing
Mega Corporation
Balance Sheet
January 31, 1999
(Dollars in thousands)
Assets
Cash
Other assets
Total assets
$22,000
38,000
$60,000
Liabilities
Note payable
$1,000
Other liabilities 14,000
Bonds payable
5,000 $20,000
Owners' equity
Common stock 35,000
Retained earnings 5,000 40,000
Total L & OE
$60,000
Notice that $20 million has been added to both
cash and common stock.
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Debt or Equity?
 Prior to obtaining the extra $20 million,
Mega Corporation had equal amounts of
debt and equity financing.
 This question boils down to the choices
of having the $20 million show up in the
debt section of the balance sheet or in
the equity section.
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Debt or Equity?
 If Mega issues bonds, their debt would
now be twice as large as the equity.
Interest payments would be required by
law, and the $20 million principal would
have to be repaid at the end of the term.
 Interest on the bonds would be a tax
deductible expense for Mega, thereby
reducing the true cost of the interest.
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Debt or Equity?
 If Mega issues stock, they will have no
required fixed payments to make.
Dividends could be paid to the
shareholders, but they need not be. Mega is
under no obligation to return the $20 million
to the investors.
 However, by issuing stock, there is a
potential dilution of the ownership interests
currently held by stockholders. In other
words, the pie is now sliced into many more
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pieces.
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Which is Better?
 There is no definitive answer to this question,
just as there was no definitive answer to the
question in the text about which type of
investment is better.
 So much rides on the success or failure of the
company’s future operations. If they are very
successful, they should be able to easily
repay the debt. However, if equity financing
was used and they again are successful, then
stockholders would likely benefit more than if
debt financing was used.
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Discussion Questions
 Can you think of an alternative way for
Mega Corp. to raise the $20 million they
need?
 What would be the effect of issuing
preferred stock? Where does it show
up on their balance sheet? Are they
obligated to make annual payments?
Are they obligated to pay it back
someday?
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End of Chapter 4
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