Q8-1. Current liabilities are obligations that require payment within the coming year or operating cycle, whichever is longer.
Generally, current liabilities are settled with existing current assets or operating cash flows.
Q8-2. An accrual is the recognition of an event in the financial statements even though no external transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues).
Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expenses.
Q8-3. The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bondholder. The market rate is the rate of return expected by investors who purchase the bonds. The market rate determines the market price of the bond. It incorporates the current risk free rate, expectations about the relative riskiness of the borrower, and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.
Q8-4. Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the prevailing interest rates, which fluctuate continuously. Differences between the market price of a bond and its carrying amount (net book value) represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized if the issuer repurchases the bonds because at that point the gains or losses become “realized.”
Gains and losses from bond redemptions are not real economic gains and losses. The recognition of the gain (loss) on redemption results from the use of historical costing for bonds. The gain (loss) that is reported upon redemption will be offset by correspondingly lower (higher) interest payments in the future. The financial statements recognize neither the present value of these future interest payments, nor the present value of the difference between the current face amount of the bond and the former face amount. These present values exactly offset the reported gain (loss); thus, no “real” gain (loss) has been realized.
Q8-5. Debt ratings reflect the relative riskiness of the rated company. This riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.
Q8-6. Companies report gains or losses on bond redemption because they use historical cost accounting. The redemption gain or loss is offset by the present value of lower (higher) interest payments in the future. The present value of those future interest payments, as well as the present value of the difference between the current face amount of the bond and the former face amount, are not recognized in the financial statements, and no “real” economic gain or loss occurs. For analysis purposes, we typically consider gains or losses on bond redemption as transitory items.
a. NCI Building Systems does not recognize the liability related to pending litigation on the face of its balance sheet not because the liability is not probable, but because the potential loss cannot be reasonably determined. As a result, NCI references the liability in its contingency footnote and does not recognize the liability on its balance sheet.
b. The $0.1 million accrual is not a contingent liability. NCI has accrued this liability because it has made a commitment to complete site analysis and testing. It is, therefore, not subject to the two conditions that govern contingent liabilities.
M 8-8 (10 minutes)
Balance Sheet Income Statement
TransactionCash Asset
+Noncash Assets
=Liabil-ities
+Contrib. Capital
+EarnedCapital
Rev-enues
–Expen-
ses=
NetIncome
IE 24 IP 24
To accrue interest at December 31*
=+24
Interest Payable
-24RetainedEarnings
–+24
Interest Expense
=-24
* $7,200 0.08 15/365
M 8-9 (15 minutes)
a. Accounts Payable, $110,000 (current liability).
b. Not recorded as a liability; an accounting transaction has not yet occurred because Basu did not receive the drill press before year-end.
c. Liability for Product Warranty, $2,200 (current liability).
d. Bonuses Payable, $30,000 (current liability)—computed as $600,000 5%. This liability must be reported because the bonus relates to operating results of 2009.
a. Boston Scientific is offering bonds (maturing 2011) with a coupon (stated) rate of 4.25% when the market rate (yield) is higher at 4.349%. To obtain this expected rate of return, the bonds must sell at a discount price of 99.476 (99.476% of par). The other part of the issuance (maturing 2017) also sells for a discount, but the discount is smaller because the market rate and the coupon rate are closer than that for the bonds maturing in 2011.
b. The first bond matures in 2011 while the second matures in 2017. The market demands a higher rate (yield) for a longer maturity debt instrument.
M8-11 (10 minutes)
Amount paid to retire bonds ($200,000 × 101%)................................. $202,000Book value of retired bonds, net of $2,400 unamortized discount.... 197,600 Loss on bond retirement...................................................................... $ 4,400
The loss on the retirement results from Nissim’s use of historical costing for its bonds. The $4,400 loss will be offset by correspondingly lower interest payments in the future. Nissim does not recognize the present value of these future interest payments, or the present value of the difference between the current face amount of the bond and the former face amount. These present values will exactly offset the reported loss on retirement and no “real” loss has been realized.
M8-12 (10 minutes)
a. The $2 billion in 2008 and $1 billion in 2009 indicate that AMGN has debt maturing in 2008 and 2009 that will require total payment of $3 billion. AMGN will either make these payments with operating cash flows in 2008 and 2009, or it will have to issue more debt (refinance), or sell stock to pay the debt.
b. AMGN will need to pay off these debts when they mature. This will result in cash outflows that must come from operating activities if the debts cannot be refinanced prior to their maturity. The size of these payments could affect AMGN’s liquidity and or solvency in 2008 and 2009 and we need to carefully assess the company’s ability to repay the debt given current levels of cash flow and existing debt.
a. Gain on Bond Retirement: Income Statement—included with other (nonoperating) income and expense section unless it meets the tests for extraordinary treatment (i.e., unusual and infrequent).
b. Discount on Bonds Payable: Balance Sheet—shown as a deduction from Long-term Debt (Bonds Payable); netted in the presentation of long-term liabilities.
c. Mortgage Notes Payable: Balance Sheet—Long-term liability.
d. Bonds Payable: Balance Sheet—Long-term liability.
e. Bond Interest Expense: Income Statement—included with other (nonoperating) income and expenses.
f. Bond Interest Payable: Balance Sheet—included with current liabilities.
g. Premium on Bonds Payable: Balance Sheet—shown as an addition to Bonds Payable; thus, part of long-term liabilities.
h. Loss on Bond Retirement: Income Statement—included with other (nonoperating) income and expenses section unless it meets the tests for extraordinary treatment (i.e., unusual and infrequent).
M8-14 (15 minutes)
a. Financial ratios used in bond covenants are typically designed to protect the bondholders against detrimental managerial actions or excessively poor company performance. Restrictions might prohibit the impairment of liquidity, the increasing of financial leverage, and the paying of cash dividends. In addition, bondholders usually impose various covenants prohibiting the acquisition of other companies or the divestiture of business segments without bondholders’ consent. All of these covenants, by design, restrict management in such actions that might increase the bondholders’ risk.
b. Managers who face imminent default in one or more bond covenants, would likely take action to avoid such default. These actions can include, for example, operational responses, such as reducing R&D or advertising to improve profitability, or leaning on the trade (by delaying payment of bills), reducing receivables (via early payment incentives for customers), or reducing inventory (by marketing promotions or delaying restocking) to boost cash balances. Actions can also include fraudulent or aggressive accounting tactics, such as improper recognition of revenues or delayed recognition of expenses.
M8-15 (15 minutes)
In $000
Balance Sheet Income Statement
TransactionCash Asset
+Noncash Assets
=Liabil-ities
+Contrib. Capital
+EarnedCapital
Rev-enues
–Expen-
ses=
NetIncome
LTD 427 Cash 412 GN 15
To retire bonds at 103 and report gain on bond retirement*
-412Cash =
-427Long-Term
Debt
+15RetainedEarnings
+15Gain on
Bond Retirement
– =+15
* Retirement price = $412,000, computed as $400,000 × 103%.Original net book value of bonds = $432,000, computed as $400,000 × 108%Net book value of bonds at retirement = $427,000, computed as $432,000 - $5,000.
To retire bonds at 101 and report loss on bond retirement*
-252.5Cash =
-243Long-Term
Debt
-9.5RetainedEarnings
–+9.5
Loss on Bond
Retirement
=-9.5
* Retirement price = $252,500, computed as $250,000 × 101%Original Net book value of bonds = 250,000 × 96% = $240,000Net book value of bonds at retirement = $240,000 + $3,000 = $243,000
M8-17 (10 minutes)
Nissim: $18,000 × 0.10 × 40/365 = $197.26
Klein: $14,000 × 0.09 × 18/365 = 62.14
Bildersee: $16,000 × 0.12 × 12/365 = 63.12$322.52
M8-18 (10 minutes)
a. Financial leverage (which measures debt levels) is one of the ratios that credit-rating agencies use to determine their ratings. Generally, the higher (lower) the financial leverage, the lower (higher) the bond rating. Therefore, by reducing its financial leverage, Cummins will improve its bond rating. In short, all else equal, less debt suggests a greater likelihood of payment on that lower level of debt.
b. Higher credit ratings on debt issues, reduce the yield expected by investors and, therefore, higher debt issuance proceeds realized by the issuing company. This implies that a higher credit rating for Cummins will lower its borrowing costs.
a. Total expected failures from units sold (69,000 0.02)................ 1,380Average cost per failure.................................................................. $100 Total warranty expense for the current period.............................. $138,000
b. Total expected failures from units sold (69,000 0.02)................ 1,380Units repaired during the period.................................................... 1,000Expected units left to be repaired................................................... 380Average cost per failure.................................................................. $100 Total warranty liability at end of current period............................. $ 38,000
At the end of the current period, Waymire will have a product warranty liability of $38,000 related to current period sales. This amount will cover the expected $100 repair costs of the additional 380 units expected to fail in the next period.
c. The warranty liability should be equal, at all times, to the expected dollar cost of future repairs. A key analysis issue is whether the warranty liability exists and, if so, is it at the correct amount. Computing the warranty-expense-to-sales ratio (common-size warranty expense) will enable a comparative analysis over several periods. We must recognize that understating (overstating) the accrual overstates (understates) current period income at the expense (benefit) of future income. This provides managers the opportunity to set up a “cookie jar” reserve for warranties.
E8-24 (20 minutes)
1. Neither record nor disclose (the loss is not probable, nor reasonably possible).
2. Record a current liability for the note. At the financial statement date, record a liability for any interest that has been incurred since the note was signed.
3. Disclose in a footnote (the loss is reasonably possible but the amount cannot be estimated).
4. Record warranty liability on the balance sheet and recognize an expense in the income statement (costs are probable and reasonably estimable).
* Harley does not disclose the composition of the settlements made. These settlements typically include both cash payments (to consumers or for repair labor) and to inventories (parts and finished goods)
b. Harley’s warranty accrual for both 2007 and 2006 is slightly less than the payments it has made to warranty claimants. This tends to support the adequacy of the warranty accrual for 2007. We do not know, however, the overall quality of the motorcycles that Harley has been selling recently. Therefore, it is impossible to assess whether the reserve is adequate to cover the liability on those recent sales. The only evidence we have, is the size of the accrual compared with the actual claims to date, which gives us some comfort that the prior years’ accruals have been adequate.
E8-26 (15 minutes)
Demski company must accrue the $25,000 of wages that have been earned even though these wages will not be paid until the first of next month. The accrual will:
increase wages payable by $25,000 on the balance sheet (current liability)
increase wages expense by $25,000 in the income statement (operating expense)
Failure to make this accrual (called an accounting adjustment) would understate liabilities, understate wages expense, overstate income, and overstate stockholders’ equity.
a. Selling price of $300,000, 15-year, 10% semiannual bonds, discounted at 8%:
Present value of principal repayment ($300,000 0.30832)......... $ 92,496Present value of interest payments ($15,000 17.29203)............ 259,380Selling price of bonds..................................................................... $351,876
i $300,000 × 0.10 × 6/12 = $15,000 cash payment; 0.04 × $351,876 = $14,075 interest expense; the difference is the bond premium amortization ($15,000 – $14,075 = $925), which reduces the carrying amount of the bond by $925.
ii 0.04 × ($351,876 $925) = $14,038 interest expense. The difference between this amount and the cash payment of $15,000 is the bond premium amortization ($15,000 – $14,038 = $962), which reduces the carrying amount of the bond by $962.
i 0.06 × $700,000 = $42,000 interest expense. The difference between interest expense and the cash payment is the reduction of the principal amount of the loan ($50,854 – $42,000 = $8,854).
ii 0.06 × ($700,000 - $8,854) = $41,469 interest expense. The difference between interest expense and the cash payment is the reduction of the principal amount of the loan ($50,854 – $41,469 = $9,385).
a. Credit rating companies such as the four NRSROs listed, typically utilize financial ratios that measure liquidity and solvency (and sometimes profitability). Liquidity is measured with ratios like the current ratio, quick ratio, and various operating cash flow to liabilities ratios. Solvency is measured using financial leverage, debt to equity, times interest earned, and various cash flow to financial payment ratios.
b. When credit rating agencies reduce a company’s rating, it implies they view the company as increasingly risky with respect to the probability of default and bankruptcy. Lenders require a higher rate of interest as compensation for such additional risk. At some point, the borrower will be considered to be of sufficiently low quality that it is no longer considered to be of “investment grade,” meaning that institutional investors are precluded from investing in debt issued by that company. At that point, the range of possible buyers of its debt is severely limited and the company likely will find it increasingly difficult to access credit markets.
c. To improve its credit ratings, Ford must improve its liquidity and solvency and/or reduce its debt payments (by reducing its debt level). All of these actions, while serving to improve its credit ratings, entail certain costs that Ford must seriously consider. For example, increasing liquidity by reducing inventories or foregoing capital expenditures can impact Ford’s sales and competitive position. Likewise, reducing debt by issuing equity is costly because equity capital is usually more expensive (due to the subordinated position of equity investors vis-à-vis creditors and also the non-deductibility of dividends for tax purposes). In sum, Ford must carefully weigh the costs and benefits of various actions it can undertake to increase its credit ratings.
1 $500,000 × 0.09 × 1/2 = $22,500 interest expense. Since the bonds were sold at par, there is no discount or premium amortization.
2 Cash required to retire $300,000 of bonds at 101 = $300,000 × 1.01 = $303,000. The difference between the cash paid and the carrying amount of the bonds is the loss on the redemption. In this case, the loss is $3,000.
1 The bond is reported at its sale price, which is par value of $250,000 less the discount of $29,224.2 $10,000 cash paid = bond face amount × coupon rate ($250,000 × 0.04). The $11,039 interest
expense = bond carrying amount × discount rate ($220,776 × 0.05). The difference between the two is the amortization of the discount, which increases the bond carrying amount.
3 $10,000 cash paid = bond face amount × coupon rate ($250,000 × 0.04). The $11,091 interest expense = bond carrying amount × discount rate [($220,776 + $1,039) × 0.05]. The difference between the two is the amortization of the discount, which increases the bond carrying amount.
Present value of principal repayment ($800,000 0.20829)...........$166,632Present value of interest payments ($36,000 19.79277).............. 712,540Selling price of bonds.......................................................................$879,172
1 The bond is reported at its sale price, which represents the par value of $800,000 plus the premium of $79,172.
2 The cash paid = bond face amount × coupon rate ($800,000 × 0.045 = $36,000). The interest expense = bond carrying amount × discount rate ($879,172 × 0.04 = $35,167). The difference between the two is the amortization of the premium, which decreases the bond carrying amount .
3 The cash paid =bond face amount × coupon rate ($800,000 × 0.045 = $36,000). The interest expense = bond carrying amount × discount rate [($879,172 - $833) × 0.04 = $35,134]. The difference between the two is the amortization of the premium, which decreases the bond carrying amount.
a. There is an inverse relation between interest rates and bond prices (to see this, look at the decreasing discount rate as the yield rate increases in present value tables of Appendix A). Given that Deere’s 7.125% debentures now trade at a premium (134.29) and assuming that Deere’s credit ratings have not changed, we conclude that interest rates for this type of debt have declined below 7.125% since the bonds were issued.
b. No, the change in interest rates since Deere issued the notes does not affect interest expense. Once the notes are recorded on the balance sheet, neither the coupon rate nor the yield (market) rate used to compute interest expense is changed. Notes (and bonds) are recorded at historical cost (like nearly all other balance sheet assets and liabilities, except marketable securities acquired as passive investments). As a result, changes in the general level of interest rates have no effect on Deere’s reported interest expense (or the interest payments) reflected in Deere’s financial statements.
c. Because the bonds trade at a premium in the market (134.29), Deere would be paying more to retire the bonds than their balance sheet (carrying) value. Deere’s cash outflow would be $402.87 million ($300 million × 134.29%). This would result in a loss on repurchase of debentures of $102.87 million ($402.87 million - $300 million, which would lower current income. This loss would be reported in current income from continuing operations unless it meets the test for an extraordinary item (unusual and infrequent).
d. Deere must repay the face amount of the bonds at maturity. Because this is the only cash flow that the bondholders will receive, the market price of the bonds will be equal to the face amount at that time. For Deere, that would be $300 million at maturity. (Assumes interest payment was already distributed.)
Present value of principal repayment ($600,000 0.09722)...........$ 58,332Present value of interest payments ($33,000 15.04630).............. 496,528Selling price of bonds.......................................................................$554,860
1 The bond is reported at its sale price, which is par value of $600,000 less the discount of $45,140.2 $33,000 cash paid = bond face amount × coupon rate ($600,000 × 0.055). The $33,292 interest
expense = bond carrying amount × discount rate ($554,860 0.06). The difference between the two is the amortization of the discount, which increases the carrying amount of the bond.
3 $33,000 cash paid = bond face amount × coupon rate ($600,000 × 0.055). The $33,309 interest expense = bond carrying amount × discount rate [($554,860 + $292) × 0.06 = $33,309]. The difference between the two is the amortization of the discount, which increases the bond carrying amount.
a. Selling price of bondsPresent value of principal repayment ($400,000 0.61391)....... $245,564Present value of interest payments ($26,000 7.72173)............ 200,765Selling price of bonds.................................................................... $446,329
1 The bond is reported at its sale price, which represents the par value of $400,000 plus the premium of $46,329.
2 The cash paid = bond face amount × coupon rate ($400,000 × 0.065 = $26,000). The interest expense = bond carrying amount × discount rate ($446,329 × 0.05 = $22,316). The difference between the two ($3,684) is the amortization of the premium, which decreases the carrying amount of the bond.
3 The cash paid = bond face amount × coupon rate ($400,000 × 0.065 = $26,000). The interest expense = bond carrying amount × discount rate [($446,329 - $3,684) × 0.05 = $22,132]. The difference between the two ($3,868) is the amortization of the premium, which decreases the carrying amount of the bond.
a. The current maturities of long-term debt are repayments of long-term debt that must be made during the next year. Because they represent a current obligation of the company, they are included among current liabilities on the balance sheet. PBG chose to group its current maturities of $7 million with its other short-term debt rather than report them as a separate line in the current liabilities section of the balance sheet. The latter is the usual custom.
Companies report maturities so that financial statement users can assess future cash outflows. In particular, the $1,300 million of long-term debt scheduled to mature in 2009 must be repaid within two years of the balance sheet date.
The $1,300 million amount is important to our analysis of the company’s solvency. The company has two options in settling its debt: 1) refinance the maturing debt with a new debt issuance, or 2) repay the debt from cash flows in the year the debt matures. PBG generated $1,437 million of cash from operating activities in 2007, the year that this debt footnote is reported. A current maturity of $1,300 million would, therefore, require the use of nearly all of this operating cash flow if PBG cannot refinance the debt. Accordingly, the magnitude of this debt and its upcoming due date should be viewed with some degree of concern.
b. There is an inverse relation between bond price and effective bond yield. The information here reveals that the PBG bond maturing in 2029 is selling at a discount (98.919% of par). This discount will cause the effective yield to be more than the 7% coupon on this bond (7.06% in this case). The market rates reflect underlying interest rates and risk premia as of December 2008, whereas PBG established the coupon rates when the bond was issued. Thus, assuming that the bonds were originally issued at par, the discounted price that exists at December 2008 (98.919% of par) reflects the effect of increasing interest rates and/or deteriorating credit position of PBG. Since the problem assumes constant credit ratings, the discount must have resulted from an overall increase in market interest rates since PBG issued the bond.
c. Lenders require bond covenants because lenders do not have voting power like shareholders do. Lenders must, therefore, exercise their control over the company via loan covenants. The covenants cited by PBG relate to: the maximum proportion of debt in relation to equity capital the amount of debt in relation to earnings before interest, taxes and
depreciation (EBITDA) the level of secured debt as a percentage of total assets senior notes that limit certain managerial actionsBy limiting the amount of debt that PBG can issue, lenders seek to control the default risk. These covenants, while beneficial to lenders, limit PBG’s flexibility, potentially to the detriment of shareholders.
d. Discounts arise when the market rate is higher than the coupon rate on the date the bond is issued. Subsequent to issuance, PBG will amortize the discounts to interest expense; that is, the reduction of the discount increases PBG’s reported interest expense each period.
P8-38 (20 minutes)
a. CVS paid $468.2 million for interest in 2007. Its average long-term debt during 2007, is $7,769.7 million [($10,481.9 million + $5,057.4 million) / 2]. Therefore, the average coupon rate is 6.03%, computed as $468.2 / $7,769.7.
CVS recorded interest expense of $468.3 million in 2007. This yields as average effective rate of 6.03%.
b. CVS reports coupon rates ranging from 4.00% (on $650 million) to 8.52% (on $44.5 million). Thus, the average coupon rate of 6.03% seems reasonable given the information disclosed in the long-term debt footnote. One might also weight the given interest rates by the total loan amounts to better estimate that rate.
c. Interest paid can differ from interest expense if the bonds are sold at a premium or at a discount. Interest expense is computed using the effective interest rate method, which uses the debt’s net book value and the effective (yield) interest rate (the market rate prevailing when the bond was issued). CVS’s interest expense and interest paid are nearly equal, which means that the company issued most of its debt at par.
d. The current maturities of long-term debt are repayments of long-term debt that must be made during the next year. Because they represent a current obligation of the company, they are included among current liabilities on the balance sheet. Companies report maturities so that financial statement users can assess future cash outflows. In particular, the $1.8 billion of long-term debt scheduled to mature in 2010 must be repaid within three years of the balance sheet date. The $1.8 billion amount is important to our analysis of the company’s solvency. The company has two options in settling its debt: 1) refinance the maturing debt with a new debt issuance, or 2) repay the debt from cash flows in the year the debt matures. CVS generated $ 3,229.7 million of cash from operating activities in 2007, the year that this debt footnote is reported. A current maturity of $1.8 billion would, therefore, require the use of over half of this operating cash flow if CVS cannot refinance the debt. Accordingly, the magnitude of this debt and its upcoming due date should be viewed with some degree of concern.
e. There is an inverse relation between bond price and effective bond yield. The information here reveals that the CVS bond maturing in 2017 is selling at a discount (86.539% of par). This discount will cause the effective yield to be more than the 5.75% coupon on this bond (7.96% in this case). The market rates reflect underlying interest rates and risk premia as of December 2008, whereas CVS established the coupon rates when the bond was issued. Thus, assuming that the bonds were originally issued at par, the discount that exists at December 2008 reflects the effect of increasing interest rates and/or deteriorating credit position of CVS. Since the problem assumes constant credit ratings, the discount must have resulted from an overall increase in market interest rates since CVS issued the bond.
a. The total face amount is $2,110 million. The unamortized discount and debt issuance costs at year-end 2007 are $19 million and the current maturities of long-term debt are $41 million, resulting in a net amount of $2,050 million reported on Southwest’s balance sheet as long-term portion of debt.
From the last paragraph of the footnote, we see that the scheduled maturities of this indebtedness are: $40 million in 2008, $42 million in 2009, $50 million in 2010, $44 million in 2011, $418 million in 2012, and $1.5 billion, thereafter.
Analysts monitor these scheduled maturities to assess amounts coming due over the next few years. Excessive payments in any one year might present a cash flow problem if the debt cannot be refinanced. Such information can also be useful in forecasting cash flows. Southwest Airlines has structured its debt with relatively long maturities. As a result, no substantial maturities occur during the next five years.
b. It is rarely the case that companies’ interest expense and interest payments are the same. The difference arises from the amortization of any discounts or premiums on the debt—recall, interest expense is equal to cash paid plus discount amortization (or less premium amortization). Southwest Airlines’ footnote only reports the net discount—meaning that actual gross discounts and gross premiums are much higher with varying amortization periods.
c. Credit rating agencies assess companies’ default risk by gauging the level of debt in relation to the companies’ operating cash flow and total assets. This is because cash flow is the primary source of repayment of the bonds and because assets serve as a secondary source (collateral) in the event of default. Credit rating agencies also look at profitability ratios and the ratios for long-term creditworthiness (see the Appendix to Module 4).
d. The market value of these notes is $385 million × 0.97290 = $374.57 million.
The difference between the current trading price of $374.57 million and its face amount of $385 million, is $10.43 million. We know that notes are reported at historical cost (face value less unamortized discount, or plus unamortized premium). The current market value of the notes is, therefore, not reflected in the balance sheet.
If Southwest were to repurchase these notes, the difference would be reported as a gain in the current income statement. This is because Southwest would pay market value to repurchase the notes, which is less than the notes’ carrying value on Southwest’s balance sheet.
Since these notes have declined in value subsequent to their issuance, market interest rates must have increased. Another possibility is that Southwest’s credit rating has deteriorated while the interest rates have remained unchanged (or a combination of these two factors).
e. The table generally reveals the following relation: the longer the time to maturity, the higher the yield. Typically, there is an increasing relation between the term period of the debt and its yield. This is a general relation that exists in the market. The higher yields compensate investors for having their money tied up for longer periods of time, resulting in increased collection (credit quality) risk and increased inflation (loss of purchasing power) risk.
a. The Comcast ratios fit into the following debt classifications using the table results from Exhibit 8.6:
Ratio Level Implied Bond Rating
EBITA / Average assets 6.95% B/C
EBITA / Interest expense 3.40 Ba/B
EBITA margin 41.70% Aaa
Operating margin 16.57% Aa/A
(Funds from operations + Interest expense) / Interest expense
4.84 Ba
Funds from operations / Debt 28.07% Baa/Ba
Debt / EBITDA 2.43 Baa/Ba
Debt / Book capitalization 31.39% Aaa/Aa
Comcast carries substantial levels of debt, but also has substantial equity capital that reduces its Debt/Book capitalization ratio and qualifies it for a Aaa/Aa rating on this dimension. In addition, its EBITA margin is very strong (Aaa level). From a capitalization and profitability standpoint, the company might warrant a higher credit rating, but the cash flow-related ratios and those that incorporate its substantial asset base are solidly in the B/C range, which reduce the company’s current rating to Baa, the lower end of investment-grade debt.
This strategy will not work. As the coupon rate is lowered, the market price of the bond must fall in order to provide the yield that investors demand from a company of like risk. This will result in the bond selling at a discount. The reported interest expense on the income statement will be equal to the cash interest paid plus the amortization of the discount. The result will be an effective cost for the bond (interest expense / carrying amount) that is equal to the yield that investors demand. The coupon rate, therefore, does not affect the interest expense reported in the income statement. The selling price of the bond will always be adjusted to yield a return commensurate with the relative riskiness of your company and the maturity of the bond issue.
MA 8-42 (15 minutes)
Failure to abide by bond covenants can result in serious consequences. Ensuring that the company has complied with such restrictions is an important area of corporate governance. Companies can utilize internal and external auditing to monitor compliance. The board of directors must also be aware of the possibility of earnings management in order to avoid default on bond covenants. As the possibility of default increases, so does management’s desire to avoid default by whatever means it can, including earnings management.
