Bonds - Definition of Terms
Bond Certificate - paper acknowledging the debt (typically has railroad cars on it)
Bond Issue - total amount issued at one time
Bond Indenture - legal document describing the rights of bondholders and restrictions on them
Secured vs. Unsecured - unsecured are call debenture bonds
Term vs. Serial - term comes due at a specified time, serial has payments over time. usually municipal and almost never corporate.
Registered vs. Coupon - almost all are registered now. firm knows who holds them.
Bond rate may be more or less than the market rate for comparably risky assets.
If bond rate is less than market, it will be sold at a discount.
If the bond rate is higher than market, it will be sold at a premium.
Thursday, October 30, 2008
Lecture 8 - Long-term Liabilities
Long-term Liabilities
Management Issues
How do you determine whether to borrow money and increase debt or to issue stock to raise stock. Issuing stock dilutes it. It also may decrease shareholder confidence. It also requires more dividends. Debt, on the other hand, increases risk to the company because there is now a liability to repay the debt. Debt has the benefit that the interest on the debt is tax deductible, whereas the increase in dividends to stockholders is not.
Financial Leverage
This is the excess of the Return on Total Investment over the Interest Rate on Debt. It can be either positive or negative.
Positive leverage allows you to increase your return on equity by borrowing at a rate lower than return on investment.
Negative leverage decreases your ROE when you borrow at a high rate than the ROI.
Interest Coverage
Banks make this calculation in determining how much to lend to a firm.
Amount Available to Pay Interest / Interest Expense
Amount available to pay interest = net income + taxes + interest
(Some ppl add back the depreciation, but we don't and the book doesn't.)
Management Issues
How do you determine whether to borrow money and increase debt or to issue stock to raise stock. Issuing stock dilutes it. It also may decrease shareholder confidence. It also requires more dividends. Debt, on the other hand, increases risk to the company because there is now a liability to repay the debt. Debt has the benefit that the interest on the debt is tax deductible, whereas the increase in dividends to stockholders is not.
Financial Leverage
This is the excess of the Return on Total Investment over the Interest Rate on Debt. It can be either positive or negative.
Positive leverage allows you to increase your return on equity by borrowing at a rate lower than return on investment.
Negative leverage decreases your ROE when you borrow at a high rate than the ROI.
Interest Coverage
Banks make this calculation in determining how much to lend to a firm.
Amount Available to Pay Interest / Interest Expense
Amount available to pay interest = net income + taxes + interest
(Some ppl add back the depreciation, but we don't and the book doesn't.)
Lecture 8 - Long-Term Assets
Definition of Long-Term Assets
Long Term Assets are assets that have a useful life of more than 1 year and are used in the operation of the business (not for investments or for sale to customer). They may be tangible or intangible.
Assets that are for sale to customer are classified as inventory.
Financing
Long-term assets are generally financed for the term of the life of the asset.
If you don't do that, problems can arise, such as the Savings and Loan Crisis of the 1980s.
S&Ls were once limited in their investments. They would invest in local mortgages. In 1980, they were deregulated and they could invest anywhere and in any thing. The mortgages were their assets. The deposits (savings accts and CDs) were their liabilities. CDs typically have short term maturity (less than 5 years). Short term interest went up and the mortgage rates were constant and low. Investors continued to invest in CDs because they were insured by the FDIC. The Resolution Trust Corporation bailed them out.
Accounting for Acquisiton of Long-Term Assets
All costs incurred in the purchase of the asset and preparing it for use are included in the cost. Such as tariffs, cost to tear-down an existing building, legal fees, commissions, delivery charges
Depreciation
Depreciation is used to record wear and tear on the long-term assets over time.
Debit Depreciation Expense
--- Credit Accumulated Depreciation - Equipment
Impairment
You mark down an asset to its fair market value from its carrying value if the fair market value is lower. Carry value = cost-accumulated depreciation. Only write down the value of the asset if the carry value exceeds the undiscounted projected cash flows.
Example: Quaker Oats bought Snapple. But Snapple didn't produce. Nonetheless, the value of Snapple was still higher than its carry value.
This last rule does not conform to internation accounting standards and may be subject to change in the future.
Depreciation
In order to calculate depreciation, you must know
Straight Line Depreciation
In this method:
Depreciation Expense per Year = (1/useful life) x (cost - salvage)
See SE5 page 497
Partial year depreciation is prorated. Note: This type of question (where you have partial year depreciation) is on the final. So, be prepared!
Unit of Production Depreciation
Not used very much, but it's related to depletion.
Amount of depreciation should be relative to the utilization of the asset. Rather than # of years, use this year's activity.
Depreciation expense for Year = (this year's activity/estimated total activity) x (cost - residual value)
See SE6 page 498
After the asset reaches the residual/salvage value, you stop depreciating and leave it on the books at the residual/salvage value.
Double Declining Balance Depreciation
This is primarily used for tax accounting. The idea is that the depreciation is twice the normal depreciation, but use accumulated depreciation instead of salvage value.
Depreciation expense for the year = 2 x (1/useful life) x (cost - accumulated depreciation)
See SE7 page 498
Repairs and Improvements
Normal repairs are expensed.
Debit Repairs Expense
--- Credit Cash
But if the repairs actually extend the useful life of the asset, it's an extraordinary repair and you record it in a way to increase the carry value of the asset.
Debit Accumulated Depreciation
--- Credit Cash
If you literally add on to the asset or make it significantly better, you increase the value of the asset
Debit Asset
--- Credit Cash
Abandonment of an Asset
When you walk away from an asset, you record the abandonment of the asset:
Debit Loss on Abandonment (and expense account)
Debit Accumulated Depreciation (to get that off the books)
--- Credit Asset (to get that off the books)
Sale of an Asset
Depreciate for part of the year
Debit the Loss on Sale or Credit the Gain on Sale
Land
Land is not depreciated. But if you pave it as a parking lot, you would depreciate the pavement cost. If the land comes with a building, separate them out and depreciate the building, but not the land.
Natural Resources
If you buy land for it's minerals or other resources, you depreciate those resources with "depletion".
Depletion expense for the year = (this year's activity/estimated total activity) x (cost - residual value)
This is similar to the unit of production method above.
Intangible Assets
These are assets that are used in the business and have a useful life, but are intangible. Accounting rules changed recently and it was decided that intangible assets should be amortized over time. This is similar to depreciation with tangible assets. Always use straight line method with amortization.
If it has an unlimited useful life, review it at the end of each year for impairment. If it has been impaired, write it down.
Examples: patent, copyright, leasehold, leasehold improvement, trademark, franchise, goodwill, r&d, computer software costs
Patent gives you an exclusive right to sell. US patents do not apply to Europe. If you manufacture in Africa, you don't need a patent unless you will sell there.
Leasehold is the acquisition of the remaining terms of an existing lease, i.e a sublease.
A leasehold improvement is when you improve any property that you lease, either regular or sub lease. Ex: new carpeting or a building on leased property. It's intangible because you don't end up owning these improvements, only the right to use them for the duration of the lease.
Franchise goes on the franchisee's books.
Goodwill
Excess of what you paid over the fair market value of what you acquire in a business transaction.
Record this as:
Debit Assets (at Fair Market Value)
Debit Goodwill
--- Credit Cash
Historically, goodwill was amortized over a period of not more than 40 years. That's the old rule. Around 1999/2000, FASB changed and decided that it must by tested for impairment each year and written down if there is an impairment.
Classic case was Time Warner when they acquired AOL. They paid much more than the FMV of the underlying value - about $120b. When the rule changed and they had to check for impairment, they had to write down $90b. The largest quarterly loss in history.
At about the same time, Enron restated their financial statements by about $80m-$1b. Enron went bankrupt, but AOL/TW stayed in business. How is that possible? It's because people lost trust in Enron, whereas AOL/TW was just a mistake.
Research & Development
R and D is expensed
Computer Software Costs
These costs are also expensed except when you're developing the software for sale. From the point that you determine that there is a market for it, you can capitalize the costs.
US Income Tax Depreciation Rules
This is called modified accelerated cost reduction (MACRS). It's based on tables which are based on the computations that we made earlier - straight-line, unit of production, etc. Real property (fixed in place) is generally straight line. Personal (moveable) property uses declining balance.
Long Term Assets are assets that have a useful life of more than 1 year and are used in the operation of the business (not for investments or for sale to customer). They may be tangible or intangible.
Assets that are for sale to customer are classified as inventory.
Financing
Long-term assets are generally financed for the term of the life of the asset.
If you don't do that, problems can arise, such as the Savings and Loan Crisis of the 1980s.
S&Ls were once limited in their investments. They would invest in local mortgages. In 1980, they were deregulated and they could invest anywhere and in any thing. The mortgages were their assets. The deposits (savings accts and CDs) were their liabilities. CDs typically have short term maturity (less than 5 years). Short term interest went up and the mortgage rates were constant and low. Investors continued to invest in CDs because they were insured by the FDIC. The Resolution Trust Corporation bailed them out.
Accounting for Acquisiton of Long-Term Assets
All costs incurred in the purchase of the asset and preparing it for use are included in the cost. Such as tariffs, cost to tear-down an existing building, legal fees, commissions, delivery charges
Depreciation
Depreciation is used to record wear and tear on the long-term assets over time.
Debit Depreciation Expense
--- Credit Accumulated Depreciation - Equipment
Impairment
You mark down an asset to its fair market value from its carrying value if the fair market value is lower. Carry value = cost-accumulated depreciation. Only write down the value of the asset if the carry value exceeds the undiscounted projected cash flows.
Example: Quaker Oats bought Snapple. But Snapple didn't produce. Nonetheless, the value of Snapple was still higher than its carry value.
This last rule does not conform to internation accounting standards and may be subject to change in the future.
Depreciation
In order to calculate depreciation, you must know
- original cost
- residual value
- useful life
Straight Line Depreciation
In this method:
Depreciation Expense per Year = (1/useful life) x (cost - salvage)
See SE5 page 497
Partial year depreciation is prorated. Note: This type of question (where you have partial year depreciation) is on the final. So, be prepared!
Unit of Production Depreciation
Not used very much, but it's related to depletion.
Amount of depreciation should be relative to the utilization of the asset. Rather than # of years, use this year's activity.
Depreciation expense for Year = (this year's activity/estimated total activity) x (cost - residual value)
See SE6 page 498
After the asset reaches the residual/salvage value, you stop depreciating and leave it on the books at the residual/salvage value.
Double Declining Balance Depreciation
This is primarily used for tax accounting. The idea is that the depreciation is twice the normal depreciation, but use accumulated depreciation instead of salvage value.
Depreciation expense for the year = 2 x (1/useful life) x (cost - accumulated depreciation)
See SE7 page 498
Repairs and Improvements
Normal repairs are expensed.
Debit Repairs Expense
--- Credit Cash
But if the repairs actually extend the useful life of the asset, it's an extraordinary repair and you record it in a way to increase the carry value of the asset.
Debit Accumulated Depreciation
--- Credit Cash
If you literally add on to the asset or make it significantly better, you increase the value of the asset
Debit Asset
--- Credit Cash
Abandonment of an Asset
When you walk away from an asset, you record the abandonment of the asset:
Debit Loss on Abandonment (and expense account)
Debit Accumulated Depreciation (to get that off the books)
--- Credit Asset (to get that off the books)
Sale of an Asset
Depreciate for part of the year
Debit the Loss on Sale or Credit the Gain on Sale
Land
Land is not depreciated. But if you pave it as a parking lot, you would depreciate the pavement cost. If the land comes with a building, separate them out and depreciate the building, but not the land.
Natural Resources
If you buy land for it's minerals or other resources, you depreciate those resources with "depletion".
Depletion expense for the year = (this year's activity/estimated total activity) x (cost - residual value)
This is similar to the unit of production method above.
Intangible Assets
These are assets that are used in the business and have a useful life, but are intangible. Accounting rules changed recently and it was decided that intangible assets should be amortized over time. This is similar to depreciation with tangible assets. Always use straight line method with amortization.
If it has an unlimited useful life, review it at the end of each year for impairment. If it has been impaired, write it down.
Examples: patent, copyright, leasehold, leasehold improvement, trademark, franchise, goodwill, r&d, computer software costs
Patent gives you an exclusive right to sell. US patents do not apply to Europe. If you manufacture in Africa, you don't need a patent unless you will sell there.
Leasehold is the acquisition of the remaining terms of an existing lease, i.e a sublease.
A leasehold improvement is when you improve any property that you lease, either regular or sub lease. Ex: new carpeting or a building on leased property. It's intangible because you don't end up owning these improvements, only the right to use them for the duration of the lease.
Franchise goes on the franchisee's books.
Goodwill
Excess of what you paid over the fair market value of what you acquire in a business transaction.
Record this as:
Debit Assets (at Fair Market Value)
Debit Goodwill
--- Credit Cash
Historically, goodwill was amortized over a period of not more than 40 years. That's the old rule. Around 1999/2000, FASB changed and decided that it must by tested for impairment each year and written down if there is an impairment.
Classic case was Time Warner when they acquired AOL. They paid much more than the FMV of the underlying value - about $120b. When the rule changed and they had to check for impairment, they had to write down $90b. The largest quarterly loss in history.
At about the same time, Enron restated their financial statements by about $80m-$1b. Enron went bankrupt, but AOL/TW stayed in business. How is that possible? It's because people lost trust in Enron, whereas AOL/TW was just a mistake.
Research & Development
R and D is expensed
Computer Software Costs
These costs are also expensed except when you're developing the software for sale. From the point that you determine that there is a market for it, you can capitalize the costs.
US Income Tax Depreciation Rules
This is called modified accelerated cost reduction (MACRS). It's based on tables which are based on the computations that we made earlier - straight-line, unit of production, etc. Real property (fixed in place) is generally straight line. Personal (moveable) property uses declining balance.
Lecture 8 - Capital Budgeting
The PV/FV tables can be used for Capital Budgeting.
Free Cash Flow is cash flow from cash flow from operations minus:
capital purchases
The rest of the cash flow is "free" and available for making capital purchases. How do you decide what to fund?
One way to decide is to evaluate the PV of each proposed project and fund the highest rated. However, this doesn't take into consideration the cost of the projects.
So instead, use Net Present Value, which is the PV minus the cost for the project.
Another way to rate the projects is look at the Internal Rate of Return which is the percentage return for the project.
Note: this is not an exam topic.
Free Cash Flow is cash flow from cash flow from operations minus:
capital purchases
The rest of the cash flow is "free" and available for making capital purchases. How do you decide what to fund?
One way to decide is to evaluate the PV of each proposed project and fund the highest rated. However, this doesn't take into consideration the cost of the projects.
So instead, use Net Present Value, which is the PV minus the cost for the project.
Another way to rate the projects is look at the Internal Rate of Return which is the percentage return for the project.
Note: this is not an exam topic.
Lecture 8 - The Time Value of Money (cont.)
7. Eyeballing it, the first investment will yield more. This is an annuity. Use table 4 to calculate the present value. $110 @ 6% for 3 yrs = 2.673 x 110.
In the second investment, use table 3 for the pv of a single payment. 330 @6% in year 3 = 0.840 x 330
8. In this case, the payments are not even, so the annuity table is useless. You use table 3 twice to find the pv:
pv of 500 @ 10% at end of 2 yrs = 500 x 0.826
pv of 1000 @ 10% at end of 3 yrs = 1000 x 0.751
the sum is 1164
for the second product, use table 4 to find pv of 500 @10% for 3 yrs = 500 x 2.487 = 1243
this should be obvious that the second product is better because you get the return more quickly and the time value of money says that that is more valuable.
9. 5000 now vs 2000 @10% for 3 yrs. use table 4 to get 2000 x 2.487 = ???
this will clearly be less than the 5000
10. this is equivalent of 1% for 24 periods
table typically works with: pv = factor x payment = 21.243 x 1000 = $21,243
In the second investment, use table 3 for the pv of a single payment. 330 @6% in year 3 = 0.840 x 330
8. In this case, the payments are not even, so the annuity table is useless. You use table 3 twice to find the pv:
pv of 500 @ 10% at end of 2 yrs = 500 x 0.826
pv of 1000 @ 10% at end of 3 yrs = 1000 x 0.751
the sum is 1164
for the second product, use table 4 to find pv of 500 @10% for 3 yrs = 500 x 2.487 = 1243
this should be obvious that the second product is better because you get the return more quickly and the time value of money says that that is more valuable.
9. 5000 now vs 2000 @10% for 3 yrs. use table 4 to get 2000 x 2.487 = ???
this will clearly be less than the 5000
10. this is equivalent of 1% for 24 periods
table typically works with: pv = factor x payment = 21.243 x 1000 = $21,243
Thursday, October 23, 2008
Lecture 7 - The Time Value of Money
Main Concept of the Time Value of Money
A dollar received today is worth more to you than a dollar received one year from today. Why? Not because of inflation. Even if there is no inflation because you can take the dollar, invest it and have more money at the end of the year.
Evaluating scenarios in which cash flows are generated at different points in time require us to put a value on having money for some amount of time.
The Four Tables
There are four tables (aka annuity tables) that are used to assess the value of money.
1. The future value (FV) of a dollar received today if I could earn i% per period for n periods.
Formula: FV = PV(1+i)n (Don't worry about the formulas for the exam.)
Example 1: 10 yrs at 10% = 2.594. Multiply that by 386,000 for the final answer.
Don't worry, tables will be provided for the exam.
2. The future value of a dollar received at the end of each period if I could earn i% per period for n periods. (aka future value of an annuity)
Formula: FVa = (PV(1+i)-1)/r
The table assumes annuity is "in arrears" (not annuity "due") - payments are made at the end of the period.
The table can be worked forward (example 2) or backward (example 3).
3. The present value (PV) of a dollar to be received n periods from now. This is essentially the inverse of table 1.
4. The present value of an annuity. This is the inverse of table 2. Do you take the lump sum today or the timed payments?
As the interest rate goes up, the value of the timed payments goes down. And current cash becomes more valuable.
Time Value Quiz has "oddball" questions - non-traditional context.
1. Use table 4 to get present value of the mortgage. 10% for 30 yrs is 9.427. multiply by 10,000 monthly payment = 94,270.
2. How much would remain on the mortgage after the first year? make the same calculation with 29 periods = 93,700. principle went down by 570, rest was interest. uggh!
3. Joe the plumber makes $50k. He can buy his business for $150k. Only consider the excess $100k. 10% for 5 yrs has a present value of 3.791. He should only pay $379,100.
4. Amt of Payment = FV / Factor = 200,000/15.94 (from table 2 - 10% for 10 yrs)
could this be calculated using table 4??
5. we need the present value of an annuity - table 4. use 20 years since it's semiannually (twice a year), but only 5% interest.
6. this is a problem for table 1 - FV of a single sum. ~7-8 years to double your money at 10%. ~14 yrs @ 5%. Shortcut: 72/%rate (x100)
why does this work??
A dollar received today is worth more to you than a dollar received one year from today. Why? Not because of inflation. Even if there is no inflation because you can take the dollar, invest it and have more money at the end of the year.
Evaluating scenarios in which cash flows are generated at different points in time require us to put a value on having money for some amount of time.
The Four Tables
There are four tables (aka annuity tables) that are used to assess the value of money.
1. The future value (FV) of a dollar received today if I could earn i% per period for n periods.
Formula: FV = PV(1+i)n (Don't worry about the formulas for the exam.)
Example 1: 10 yrs at 10% = 2.594. Multiply that by 386,000 for the final answer.
Don't worry, tables will be provided for the exam.
2. The future value of a dollar received at the end of each period if I could earn i% per period for n periods. (aka future value of an annuity)
Formula: FVa = (PV(1+i)-1)/r
The table assumes annuity is "in arrears" (not annuity "due") - payments are made at the end of the period.
The table can be worked forward (example 2) or backward (example 3).
3. The present value (PV) of a dollar to be received n periods from now. This is essentially the inverse of table 1.
4. The present value of an annuity. This is the inverse of table 2. Do you take the lump sum today or the timed payments?
As the interest rate goes up, the value of the timed payments goes down. And current cash becomes more valuable.
Time Value Quiz has "oddball" questions - non-traditional context.
1. Use table 4 to get present value of the mortgage. 10% for 30 yrs is 9.427. multiply by 10,000 monthly payment = 94,270.
2. How much would remain on the mortgage after the first year? make the same calculation with 29 periods = 93,700. principle went down by 570, rest was interest. uggh!
3. Joe the plumber makes $50k. He can buy his business for $150k. Only consider the excess $100k. 10% for 5 yrs has a present value of 3.791. He should only pay $379,100.
4. Amt of Payment = FV / Factor = 200,000/15.94 (from table 2 - 10% for 10 yrs)
could this be calculated using table 4??
5. we need the present value of an annuity - table 4. use 20 years since it's semiannually (twice a year), but only 5% interest.
6. this is a problem for table 1 - FV of a single sum. ~7-8 years to double your money at 10%. ~14 yrs @ 5%. Shortcut: 72/%rate (x100)
why does this work??
Lecture 7 - Liabilities Part 2
Estimated Liabilities
Income Taxes
Financial statements are prepared soon after the beginning of the year, but taxes aren't paid until March 15. So you may not know how much tax you'll pay when you're preparing the financial statement.
Entry for this estimation:
Debit Income Tax Expense (aka provision for income taxes)
------Credit Income Tax Liability
(ACE Question answer is false)
Product Warranties
Product warranties require two types of entries: The end of year adjustment and the provision of warranty services. See class slides for details (which assumes that the warranty provides for replacement of a damaged/defective item and so requires Cr from merchandise inventory)
Contingent Liabilities
Should it be recorded? The criteria are: is it likely to be paid out and can it be estimated?
If so,
Debit Expense related to loss on litigation
---- Credit Contingent Liability relating to litigation
(ACE Question answer is A) Which is not a contingent liability? A dividend declared, but not yet paid. It's a real liability.
Income Taxes
Financial statements are prepared soon after the beginning of the year, but taxes aren't paid until March 15. So you may not know how much tax you'll pay when you're preparing the financial statement.
Entry for this estimation:
Debit Income Tax Expense (aka provision for income taxes)
------Credit Income Tax Liability
(ACE Question answer is false)
Product Warranties
Product warranties require two types of entries: The end of year adjustment and the provision of warranty services. See class slides for details (which assumes that the warranty provides for replacement of a damaged/defective item and so requires Cr from merchandise inventory)
Contingent Liabilities
Should it be recorded? The criteria are: is it likely to be paid out and can it be estimated?
If so,
Debit Expense related to loss on litigation
---- Credit Contingent Liability relating to litigation
(ACE Question answer is A) Which is not a contingent liability? A dividend declared, but not yet paid. It's a real liability.
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