Interest Rates & BondsBond TerminologyBond SecurityPlans for Paying OffRestrictive CovenantsBond RatingsBond BasicsPreferred StockLeasingHow are leases treated for tax purposes?How does leasing affect a firm’s balance sheet?Operating vs. Capital LeasesWhat impact does leasing have on a firm’s capital structure?Assume that Lewis Securities plans to acquire some new equipment having a 6-year useful life.Other Information for LeaseExcel file used in class.42510011 0010 1010 1101 0001 0100 1011Interest Rates & BondsPrepared by Keldon BauerFIL 24042510011 0010 1010 1101 0001 0100 1011Bond Terminology•Corporate bond:–A long-term debt instrument legally obligating the corporation to repay principal and interest according to a prearranged schedule.•Indenture:–A legal contract specifying the rights and restrictions of the borrower and lender.–Trustee is a third party overseeing the indenture.42510011 0010 1010 1101 0001 0100 1011Bond Security•Secured bond:–Mortgage bond.–Insured.•Unsecured (debenture).–Priority of payment.•Convertible Bonds.•Variable-Rate Bonds.•Putable Bonds42510011 0010 1010 1101 0001 0100 1011Plans for Paying Off•Staggered Maturities:–Serial payments•Sinking-fund requirement:–A covenant in an indenture for the systematic retirement of bonds prior to maturity.•Call Provision.42510011 0010 1010 1101 0001 0100 1011Restrictive Covenants•Limitations on Future Borrowings•Restrictions on Dividends•Restrictive Ratios:–Minimum levels of working capital.–Acceptable liquidity and efficiency ratios.42510011 0010 1010 1101 0001 0100 1011Bond RatingsMoody's S & P InterpretationAaa AAA Best QualityAa1 AA+High GradeAa2 AAAa3 AA2A1 A+Upper Medium GradeA2 AA3 A2Baa1 BBB+Medium GradeBaa2 BBBBaa3 BBB2Ba1 BB+SpeculativeBa2 BBBa3 BB2B1 B+B2 BB3 B2Caa CCCVery SpeculativeCa CCC C D In DefaultJunk Bonds42510011 0010 1010 1101 0001 0100 1011Bond Basics•International bonds–Foreign bond–Eurobonds•Yankee bond42510011 0010 1010 1101 0001 0100 1011Preferred Stock•Preferred Stock Dividend:–Cumulative on noncumulative.•Preferred Stock Investors:–Generally other corporations since there is a 70% tax exclusion.•Convertible Preferred Stock.42510011 0010 1010 1101 0001 0100 1011Leasing•Genuine Leases versus Fake Leases–Lease is renting not a purchase.•Definition of Lease:–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.42510011 0010 1010 1101 0001 0100 101110How are leases treated for tax purposes?•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?42510011 0010 1010 1101 0001 0100 101111How does leasing affect afirm’s balance sheet?•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?42510011 0010 1010 1101 0001 0100 1011Operating vs. Capital Leases•The lease is a capital lease if at least one of these occurs:–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.42510011 0010 1010 1101 0001 0100 101113What impact does leasing have on a firm’s capital structure?•Leasing is a substitute for debt.•As such, leasing uses up a firm’s debt capacity.42510011 0010 1010 1101 0001 0100 101114Assume that Lewis Securities plansto acquire some new equipment having a 6-year useful life.•If the equipment is leased:–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.42510011 0010 1010 1101 0001 0100 101115Other Information for Lease•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: $200,000.42510011 0010 1010 1101 0001 0100 1011Excel file used in class.•Click
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