Long-Term Debt

Objectives:

! Extend our understanding of valuation methods beyond

simple present value calculations.

•Understand the terminology of long-term debt

Par value
Discount vs. Premium
Mortgages

! Practice bookkeeping for debt issuance, interest accruals,

periodic payments, and debt retirement.

! Understand how long-term debt affects the financial

statements over time.
15.514 2003
Session 14

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 Valuation Concepts
Annuities
Ordinary Annuity (annuity in arrears) - payments occur at the end of the
period
Annuity due (annuity in advance) - payments occur at the beginning of the
period

What is the FV of a $100 ordinary annuity at the end of 3 years at 8%?

0 1 2 3
|---------------------------|---------------------------|----------------------------|

A general formula:
FV(a) = {[(1+r)N - 1]*[1/r]}*Fixed Period Cash Flow
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 Valuation Concepts
What is the PV of a 3 year $100 ordinary annuity at 8%?
0 1 2 3
|---------------------------|---------------------------|----------------------------|

A General Formula:
PV(a) = {[1 - (1+r)-N]*[1/r]}* Fixed Period Cash Flow
Note: A perpetuity is an annuity that goes on forever. As N approaches infinity, the formula
for PV(a) becomes [1/r]*Fixed Period Cash Flow
If you were to receive $100 a year forever, the PV of that stream of payments, given r = 8%,
is 100/.08 = 1,250.
If you were to receive $100 a year for 50 years, the PV of that stream of payments, given r =
8%, is 1,223.35. Why is the difference so small?

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 Bonds - Terminology
Par value - stated or face value of the bond; the amount due at maturity
Market value - the value assigned to the bond by investors

Three interest rates are relevant to bond accounting:

Coupon rate -the rate used to determine the periodic cash payments
(if any)

(Current) Market interest rate - the rate used to determine the

current market value of the bond. The market rate is based upon
market conditions and the risk characteristics of the borrower

Effective interest rate - the market rate at issuance, used to

determine the interest expense and the book value of the liability

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 Bonds - An Introduction
If at issuance the market rate = coupon rate then market value = par value. The
bond is said to sell at par. When a bond sells at par its coupon payment is equal to
its interest expense.

While we will primarily focus on bonds sold at par, there are two other
possibilities:

If at issuance the market rate > coupon rate then market value < par value. The
difference between market value and par value is called the discount on the bond
and its coupon payment is less than its interest expense. An extreme case of this is
the zero-coupon bond.

If at issuance the market rate < coupon rate then market value > par value. The
difference between market value and par value is called the premium on the bond
and its coupon payment is more than its interest expense.

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 Bonds
Consider a loan with proceeds of $10,000 initiated on 1/1/99. The market interest
rate is 6% and final payment is to be made at the end of the third year (12/31/01).
What annual payments are required under the following three alternatives?

I. Yearly payments of interest at the end of each year and repayment of principal at
the end of the third year (typical bond terms).

II. Three equal payments at the end of each year (mortgage / new car loan terms).

III. A single payment of principal and interest at the end of year 3 (Zero-Coupon
bond).

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 Bonds - alternative payment streams
I II III
coupon mortgage zero

End of Year 1

End of Year 2

End of Year 3

Undiscounted
sum of payments

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 Accounting for a Regular Bond - at par
Example I (coupon)
A = L + E
Cash Principal -Discount
1999 10,000 10,000

Periodic payments
Cash Principal -Discount + RE
1999 (600) (600) int. exp.
2000 (600) (600) int. exp.
2001 (600) (600) int. exp.
(10,000) (10,000)

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 Accounting for a Mortgage
Example II (mortgage)
A = L + E
Cash Mortgage
1999 10,000 10,000

Periodic payments
Cash Mortgage + RE
1999 (3,741) (3,141) (600) int. exp.
2000 (3,741) (3,329) (412) int. exp.
2001 (3,741) (3,530) (211) int. exp.

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 Accounting for a Zero-Coupon Bond
Example III (zero coupon)
A = L + E
Cash Principal -Discount
1999 10,000 11,910 1,910

Periodic payments
Cash Principal -Discount + RE
1999 0 (600) (600) int. exp.
2000 0 (636) (636) int. exp.
2001 0 (674) (674) int. exp.
(11,910) (11,910)

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 Bonds - disclosures
Balance sheet
current portion of L-T debt in current liabilities
long-term debt

Income Statement
interest expense

Indirect SCF
Operations - interest accruals not yet paid, amortization of
discount/premium
Investing - purchase / sale of AFS debt
Financing - proceeds, repayment
+ supplemental disclosure of cash paid for interest

Notes
details on all of the above
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 Bonds - disclosures
Nextel Communications (partial footnote)
7.Long-Term Debt, Capital Lease and Finance Obligations

December 31,
(dollars in millions)
2001 2002
Domestic
10.65% senior redeemable discount notes due 2007,
net of unamortized discount of $59 and $136 $781 $704
9.75% senior serial redeemable discount notes due 2007,
net of unamortized discount of $86 and $180 1,043 949
4.75% convertible senior notes due 2007 354 354
9.95% senior serial redeemable discount notes due 2008,
net of unamortized discount of $168 and $303 1,459 1,324
12% senior serial redeemable notes due 2008,
net of unamortized discount of $3 and $4 297 296
9.375% senior serial redeemable notes due 2009 2,000 2,000
5.25% convertible senior notes due 2010 1,150 1,150
9.5% senior serial redeemable notes due 2011,
including a fair value hedge adjustment of $11 1,261 -
6% convertible senior notes due 2011 1,000 -
Bank credit facility, interest payable quarterly at an
adjusted rate calculated based either on the U.S.
prime rate or London Interbank Offered Rate, or
LIBOR, (4.02% to 10.44% - 2001; 8.63% to 10.44% - 2000) 4,500 4,500
Other 19 1

Total domestic long-term debt 13,864 11,278

Less domestic current portion (49) -

13,815 $11,278

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 Does the Balance Sheet Represent the Market
Value of Debt
Footnote from Shoney’s 1999 Annual Report
Oct. 31,1999 Oct. 25,1998
Subordinated zero coupon debentures,
due April 2004 (face value $179,299,000) 122,520,712 112,580,014

What is the effective interest rate of the debt?

(122,520,712/112,580,014 -1) = 8.83%

What is the market interest rate of the debt?

The WSJ (11/1/99) reports Shoney’s debt to be selling for 210 per thousand,
with 5 years until maturity. 1000 = 210*(1+r)5, 4.762(1/5)= 1+r, r=.366, or
36.6%, more than four times the interest rate used in the financial statements.
How could this be?

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 Shoney's Statement of Cash Flows
Effects of Discount Amortization
-----------------------------------­
Years Ended October 31 October 25
1999 1998
-----------------------------------­
Operating activities
Net loss $ (28,826,398) $ (107,703,920)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Depreciation and amortization 41,162,155 49,340,252
Interest expense on zero coupon
The annual discount
convertible debentures and other noncash amortization on the
charges 16,329,932 18,508,713 zeros (which is
Deferred income taxes (1,890,000) 38,088,000 equal to the annual
Gain on disposal of property, plant and
equipment (20,230,756) (9,417,828) interest expense on
Impairment of long-lived assets 18,424,046 48,403,158 the zeros) is a non-
Changes in operating assets and liabilities: cash expense and is
Notes and accounts receivable 1,834,878 1,966,717
Inventories (492,529) 1,236,546 added back to NI to
Prepaid expenses (1,676,202) 1,450,081 reconcile to OCF
Accounts payable (10,850,662) 2,524,508
Accrued expenses (7,324,161) 11,240,256
Federal and state income taxes 1,612,557
Litigation settlement 14,500,000 3,500,000
Refundable income taxes 14,005,359 (9,928,809)
Deferred income and other liabilities (444,616) 4,243,692
--------------- --------------
Net cash provided by operating activities 34,521,046 55,063,923
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Early Retirement of Debt for Less than Book Value
Example I (zero coupon)
A = L + E
Cash Principal -Discount
EB 99 11,910 1,310

You repurchase the bonds in the open market at the start of 2000 (2
years to maturity) when the market rate is 7% for $10,403 (11,910/1.07 2)
A = L + RE
Cash Principal -Discount
[Gain on retirement
(10,403) (11,910) (1,310) 197 of debt on I/S]

The gain or loss on early retirement of debt is reported as an

extraordinary item on the income statement (see Pratt, p. 569).
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Early Retirement of Debt for More than Book Value
Example I (zero coupon)
A = L + E
Cash Principal -Discount
EB 99 11,910 1,310

You repurchase the bonds in the open market at the start of 2000 (2
years to maturity) when the market rate is 5% for $10,803 (11,910/1.05 2)
A = L + RE
Cash Principal -Discount
[Loss on retirement
(10,803) (11,910) (1,310) (203) of debt on I/S]

The gain or loss on early retirement of debt is reported as an

extraordinary item on the income statement (see Pratt, p. 569).
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 Bonds - restrictions on debt
TCBY
• Borrower will at all times maintain a ration of Current Assets to Current
Liabilities … that is greater than 2.0… a Profitability ration greater than 1.5
…[defined as] the ratio of Net Income for the immediately preceding
period of 12 calendar months to Current Maturities of Long Tern Debt … a
Fixed Coverage Ratio greater than 1.0 … [defined as] the ratio of Net
Income … plus noncash Charges to Current Maturities of Long Term Debt
... plus cash dividends … plus Replacement CapEx of the Borrower
• [Borrower will not] sell, lease, transfer, or otherwise dispose of any assets
… except for the sale of inventory … and disposition of obsolete
equipment …[to] repurchase the stock of TCBY
• [Borrower agrees it will not take on new loans if] the aggregate amount of
all such loans … would exceed 25% of the consolidated Tangible Net
Worth of the Borower...

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