Long-Term Debt Objectives: ! Extend our understanding of valuation methods beyond simple present value calculations. •Understand the terminology of long-term debtPar 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 1Valuation 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 15.514 2003 Session 14 2Valuation 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? 15.514 2003 Session 14 3Bonds - 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 15.514 2003 Session 14 4Bonds - 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. 15.514 2003 Session 14 5Bonds 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). 15.514 2003 Session 14 6Bonds - 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 15.514 2003 Session 14 7Accounting 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) 15.514 2003 Session 14 8Accounting 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. 15.514 2003 Session 14 9Accounting 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) 15.514 2003 Session 14 10Bonds - 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 15.514 2003 Session 14 11Bonds - disclosures Nextel Communications (partial footnote) 7.Long-Term Debt, Capital Lease and Finance Obligations(dollars in millions) Domestic 10.65% senior redeemable discount notes due 2007, net of unamortized discount of $59 and $136 9.75% senior serial redeemable discount notes due 2007, net of unamortized discount of $86 and $180 4.75% convertible senior notes due 2007 9.95% senior serial redeemable discount notes due 2008, net of unamortized discount of $168 and $303 12% senior serial redeemable notes due 2008, net of unamortized discount of $3 and $4 9.375% senior serial redeemable notes due 2009 5.25% convertible senior notes due 2010 9.5% senior serial redeemable notes due 2011, including a fair value hedge adjustment of $11 6% convertible senior notes due 2011 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) Other Total domestic long-term debt Less domestic current portion December 31, 2001 2002 $781 $704 1,043 949 354 354 1,459 1,324 297 296 2,000 2,000 1,150 1,150 1,261 -1,000 -4,500 4,500 19 1 13,864 11,278 (49) -13,815 $11,278 15.514 2003 Session 14 12Does 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)