Effects of change in interest rate on debts and Early Retirement of Debt

Effects of changei n interest rate on debts
Changes in bond value due to changes in interest rates are not reflected in the value of bond liability.

Analysts should:
· Consider the market value of debt in the financial analysis.

Early Retirement of debt
At bond’s maturity: decrease in cash and LT liability, market value = book value

Early retirement of debt:
· The carrying value of debt liability minus the price at which it is purchased back is recorded as an extraordinary item (below the operating line, net of tax), because:
· This gain/loss is not due to the firm’s performance,
· The cause behind the gain/loss (change in interest rates) could have occurred in a different period. The gain or loss may signal an earnings change in opposite direction, that is
· If the company generate gain by retiring old low interest debt at a market price well below bookvalue (bought back at price below book value), but if it raises the proceeds by borrowing at current higher interest rate =>increase interest expense.;
· If the company generate loss by retiring old high interest debt =>can borrow at low current interest rate debt.

Zero Coupon Bond, Convertible bond, Bond with warrant, Redeemable Preferred Stock

Zero Coupon Bond
Also know as pure discount instrument.

For an extreme case of a discounted bond issue, the coupon rate is 0, so the entire interest expense goes towards amortization of the bond discount.

The carrying value of the bond grows towards par over the life of the bond. Recognized interest expense for each period by applying discount rate to book value (i.e. effective interest method or PV amortization method)

Convertible Bond:
The conversion option is ignored in accounts upon issuance and the bond is booked in the same way as non-convertibles. Option is undetachable and the interest expense of the convertible is lower {due to the conversion option the firm gives to bondholders, which is not reflected in liabilities}.

Upon conversion, reclassified from debt to equity in balance sheet.

Bond with warrant:
Option is detachable and as a sweetener , proceeds from issuance of bonds should be split into 1) pure bond valued treated as debt 2) options is treated as equity.

GAAP requires the issuer to calculate the fair value and report the warrant separately in stockholders’ equity. Accounting for bonds with warrants is closer to economic reality than that of convertible bonds.

How should an analyst treat convertibles:
· If current stock price < conversion price, treat like an ordinary bond (debt).
· If current stock price > conversion price, treat like equity.
· If current stock price is close to the conversion price, choose the more conservative treatment.

Alternatively, use option-adjusted yield as the true cost of debt.

Redeemable preferred stock:
Often recorded as a separate item between equity and debt.

Analyst should
· treated as debt and its dividends as interest payments for purpose of analysis.

Cash flow adjustment

Premium bonds:
higher cash coupon ->CFO is understated;

Discount bonds:
lower cash coupon -> CFO is overstated;

zero coupon bond:
the coupon understated the cash components of interest expense & CFO is overstated
i.e. no coupon =>CFO has no interest expense deducted =>severely understate interest expense and overstate CFO;

Analyst should:
· make adjustment which is positive for premium & negative for discount bond.

Long Term Debt - bonds

Long Term Debt is legal obligation to pay principle & interest.

Advantage of debt:
· financial leverage
· tax deductibility of interest
· no voting control

Disadvantage of debt:
· legal commitment to pay interest and principle

Interest coverage rate = (Income before tax + interest expense ) / Interest expense

Bonds:
A company can issue debt securities to finance its operations. A bond is a promise, in most cases, to pay a predetermined annual or semiannual interest payment and to pay back the principal (face value) when the bond matures.

Most US bonds provide sem-annually payment whereas most international bond are with annual payments.

Terms for bonds
· principle value (aka par, principle, maturity/redemption value, face value)
· coupon rate
· secured (backed by legal claims to specific property) vs unsecured (backed by credit),
· Ownership(bearer vs registered)
· Term to maturity (term bond vs serial bond -the bonds in an issue mature at diff pts of time)

Bonds interest expense = book value x market interest rate at issuance, as a part of CFO. For interest received, as a part of CFF; matured bond repayment, as a part of CFF

Book value of bonds = PV x market interest rate at issuance

Bonds issued at premium (coupon > yield):
· Initial liabilities value > Par value.
· Interest expense < Coupon payments.
· (Coupon payments - Interest expense) = Bond premium amortized over the life of the bond.

Bonds issued at discount (coupon >
· Initial liabilities value < Par value.
· Interest expense > Coupon payments.
· (Interest expense - Coupon payments) = Bond discount amortized over the life of the bond.

Double entries for bonds

Purpose of amortizing
· If issurance at discount:
· increase book value of bonds over time
· coupon + amortized discount = interest expense