Chapter 9: Long-Term Assets

Internal Financing

Profits generated by the company

External Financing

Funds from outside the company

Debt Financing

Borrowing money from creditors (liabilities)

Equity Financing

Obtaining investment from stockholders (stockholders’ equity)

Capital Structure

Mixture of liabilities and stockholders’ equity as business uses, such as borrowing money (debt financing) or obtaining investment from stockholders (equity financing)

Costs of Financing

Interest expenses and dividends

Installment Notes

Includes interest on borrowed amount and reduction of outstanding loan balance

Leases

Contractual arrangements by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time

Benefits to lease rather than to buy

Reduces upfront cash needed to use an asset, payments often lower than installment payments, offers flexibility and lower costs of disposing of an asset, may offer protection against the risk of declining asset values

Present Value

Amount invested now to receive more later

Amount of Future Payment (Principal), Length of Time, Interest Rate

Variables Present Value Depends On

Bond

A formal debt instrument issued by a company to borrow money

Principal/Face Amount

Stated Amount

Secured Bonds

Bonds back by collateral

Unsecured Bonds

Bonds not backed by collateral

Term Bonds

Bond issue matures on a single date

Serial Bonds

Bond issue matures in installments

Callable Bonds

Issuing company can pay off bonds early

Convertible Bonds

Investor can convert bonds to common stock

Stated Interest Rate (Coupon Rate)

Interest rate specified in the bond contract, determines the cash paid to bondholders

Market Interest Rate (Effective Interest Rate)

Interest rate not specified in the bond contract, demanded by investors for loaning money, varies minute to minute

Discount

Occurs when Stated Interest Rate is less than Market Interest Rate

Face Value (Par Value)

Stated Interest Rate is equal to Market Interest Rate

Premium

Stated Interest Rate is greater than Market Interest Rate

Cash Interest Payment = Face Amount x Coupon Rate x Time

Cash Interest Payment Equation

Interest Expense = Carrying Value x Market Rate x Time

Interest Expense Equation

Carrying Value = Prior Carrying Value + Decrease in Carrying Value

Carrying Value Equation

Early Extinguishment of Debt

When the issuing company retires debt of any type before its scheduled maturity date

Issue Price = Present Value of Face Amount + Present Value of Periodic Interest Payments

Bond Pricing Equation

Debt to Equity Ratio

A measure of risk; the higher the ratio, the higher the risk of bankruptcy

Debt to Equity Ratio = Total Liabilities / Stockholders’ Equity

Debt to Equity Ratio Equation

Times Interest Earned Ratio

An indication to the creditors of how many “times” greater earnings are than interest expense

Times Interest Earned Ratio = (Net Income + Interest Expense + Tax Expense) / Interest Expense