0011 0010 1010 1101 0001 0100 1011 Prepared by Keldon Bauer FIL 240 2 1 Interest Rates Bonds 4 Bond Terminology 0011 0010 1010 1101 0001 0100 1011 Corporate bond 2 A long term debt instrument legally obligating the corporation to repay principal and interest according to a prearranged schedule Indenture 1 4 A legal contract specifying the rights and restrictions of the borrower and lender Trustee is a third party overseeing the indenture Bond Security 0011 0010 1010 1101 0001 0100 1011 Secured bond Mortgage bond Insured Unsecured debenture Priority of payment Convertible Bonds Variable Rate Bonds Putable Bonds 2 1 4 Plans for Paying Off 0011 0010 1010 1101 0001 0100 1011 Staggered Maturities Serial payments Sinking fund requirement 2 1 4 A covenant in an indenture for the systematic retirement of bonds prior to maturity Call Provision Restrictive Covenants 0011 0010 1010 1101 0001 0100 1011 Limitations on Future Borrowings Restrictions on Dividends Restrictive Ratios 2 1 4 Minimum levels of working capital Acceptable liquidity and efficiency ratios Bond Ratings Moody s S P 0011 0010 1010 1101 0001 0100 1011 Aaa AAA Aa1 AA Aa2 AA Aa3 AA2 A1 A A2 A A3 A2 Baa1 BBB Baa2 BBB Baa3 BBB2 Ba1 BB Ba2 BB Ba3 BB2 B1 B B2 B B3 B2 Caa CCC Ca CC C C D Interpretation Best Quality High Grade Upper Medium Grade Medium Grade Speculative 2 1 4 Junk Bonds Very Speculative In Default Bond Basics 0011 0010 1010 1101 0001 0100 1011 International bonds Foreign bond Eurobonds Yankee bond 2 1 4 Preferred Stock 0011 0010 1010 1101 0001 0100 1011 Preferred Stock Dividend Cumulative on noncumulative Preferred Stock Investors Convertible Preferred Stock 2 1 4 Generally other corporations since there is a 70 tax exclusion Leasing 0011 0010 1010 1101 0001 0100 1011 Genuine Leases versus Fake Leases Lease is renting not a purchase Definition of Lease 2 1 4 Remaining life 20 after lease Term of lease 30 years Lessor must earn reasonable return Renewal terms must be consistent with value Purchase option must be for fair market value Leased property cannot be limited use How are leases treated for tax purposes 0011 0010 1010 1101 0001 0100 1011 2 Leases are classified by the IRS as either guideline or nonguideline For a guideline lease the entire lease payment is deductible to the lessee For a nonguideline lease only the imputed interest payment is deductible Why should the IRS be concerned about lease provisions 1 4 10 How does leasing affect a firm s balance sheet 0011 0010 1010 1101 0001 0100 1011 2 For accounting purposes leases are classified as either capital or operating Capital leases must be shown directly on the lessee s balance sheet Operating leases sometimes referred to as off balance sheet financing must be disclosed in the footnotes Why are these rules in place 1 4 11 Operating vs Capital Leases 0011 0010 1010 1101 0001 0100 1011 2 The lease is a capital lease if at least one of these occurs 1 Ownership transfer from lessor to lessee Lessee can purchase the property at less than fair market value at end of lease The lease runs for a period 75 percent of asset life The PV of the lease payments is 90 of initial value 4 What impact does leasing have on a firm s capital structure 0011 0010 1010 1101 0001 0100 1011 Leasing is a substitute for debt As such leasing uses up a firm s debt capacity 2 1 4 13 Assume that Lewis Securities plans to acquire some new equipment having a 6 year useful life 0011 0010 1010 1101 0001 0100 1011 If the equipment is leased 2 Firm could obtain a 4 year lease which includes maintenance Lease meets IRS guidelines to expense lease payments Rental payment would be 260 000 at the beginning of each year 1 4 14 Other Information for Lease 0011 0010 1010 1101 0001 0100 1011 2 Equipment cost 1 000 000 Loan rate on equipment 10 Marginal tax rate 40 3 year MACRS life If company borrows and buys 4 year maintenance contract costs 20 000 at beginning of each year Residual value at t 4 200 000 1 4 15 Excel file used in class 0011 0010 1010 1101 0001 0100 1011 Click here 2 1 4
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