Transcript Chapter 6

Chapter Six
Lecture Notes
Long-Term Financing
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Long-Term Financing
 Used to pay for capital assets when capital costs exceed the
cash available from operations or it would not be prudent to use
operating cash flow for capital purposes.
 Equity - additions to the permanent capital of an organization.
 Capital Campaigns - fundraising drives aimed at raising
money to pay for long-lived assets.
 Long-Term Debt - borrowed money with a maturity of more than
one year. Short-term debt refers to borrowed money that must be
repaid within one year.
 Leases - contracts to make fixed payments in return for the right
to use a capital asset.
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Types of Long-Term Debt
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Long-Term Notes - unsecured loans.
 Can be secured or unsecured (i.e. “collateralized”)
Mortgages - loans that are backed by a security interest
in land and/or buildings that are owned by the borrower.
Bonds - standardized loan agreements between borrowers
and lenders. Big amounts.
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Calculating Mortgage
Payments
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Mortgages call for equal periodic payments which repay the amount
borrowed and pay interest to the lender.
At the beginning payments are mostly interest and near the end they
are mostly principal. Mortgage payments are annuities.
Assume a 30-year, $500,000, 12% per year mortgage with monthly payments:
0
1
1%
$500,000
360
PMT
PMT
...
PMT
N = 360, i = 1%, PV = $500,000, PMT = ?
Mortgage PMT = $5,143.06 per month
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359
Bond Characteristics

Bond agreements specify:
- the amount to be repaid, called the par, principal, stated,
face, or maturity value of the bond;
- the maturity date when the money must be repaid;
- the rate of interest, called a coupon rate or stated rate, to
- be paid on the face value of the bond; and,
- the time intervals at which the interest must be paid, usually
every six months (semi-annual).

These factors are fixed for the life of the bond.
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Typical Bond Cash Flows

Bonds are an example of mixed cash flows. Here is the time line for a
ten-year, $1,000,000 face value bond that bears an interest rate of 10%
per annum and pays interest every six months.
0
1
19
20
...
5%
0
$50,000
Annuity
6
...
$50,000
Single Payment
$50,000
$1,000,000
Principal
Valuing a Bond
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Normally, bonds can be sold by their owners. But, interest
rates fluctuate on a daily basis.
Since the cash flows from bonds are fixed, bond prices
vary with changes in interest rates.
Bonds are worth the PV of the stream of cash flows paid by borrower
discounted at the prevailing market rate of interest.
Example: Suppose that we own a $1,000,000, 10%, 10-year semiannual bond and want to sell it in a market where interest rates have
risen to 12%. What will the bond be worth?
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The Cash Flows Are Fixed!
0
1
...
19
20
6%
$50,000
0
...
$50,000
$50,000
$1,000,000
Principal
The cash flows are unchanged! To value the bond we only change
the interest rate used in the PV calculations to reflect the prevailing
market rate!
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The Calculations
First, calculate the PV of the $50,000 annuity using the 12%
market interest rate.
N = 20, i = 6%, PMT = $50,000, PV = ?
PV = $573,496
Second, calculate the PV of the $1,000,000 repayment of principal.
N = 20, i = 6%, FV = $1,000,000, PV = ?
PV = $311,805
Then, add the two PVs to get the value of the bond.
Value of Bond = $573,496 + $311,805 = $885,301
Note: Excel and some calculators can do this as one calculation.
Enter N, i, FV, and PMT. Solve for PV.
=PV(rate, nper, pmt, fv, type)
=PV(6%,20,-50000,-1000000)
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Term Versus Serial Bonds
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Term bonds are all paid at one maturity date. However,
amounts can be paid into a Sinking Fund at various times to
accumulate money to repay principal at maturity.
Serial Bonds have a number of different maturity dates.
This allows some of the principal to be paid back each year
over a range of years, rather than all at once.
Call provisions allow bonds to be “called in” or repaid
before the maturity date.
 Call provisions generally increase the interest rate on
the bond when first issued, since it creates an
advantage for the borrower.
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Calculating Interest Rates
for Serial Bonds – NIC Method
$10,000 serial bond, principal payments of $1,000 at the end of Years
1 and 2, $2,000 at the end of year 3, and $3,000 at the end of years 4
and 5. Interest rates are 3, 4, 5, 6 and 7% on the respective
maturities, and the bond issue is initially sold at a $100 discount.
Par or Principal
Coupon Rate
$1,000
x
3%
1,000
x
4%
2,000
x
5%
3,000
x
6%
3,000
x
7%
Interest Payments
Plus Discount
Total Interest
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x
x
x
x
x
Years
1 =
2 =
3 =
4 =
5 =
Interest
$ 30
80
300
720
1,050
$2,180
100
$2,280
Calculating the NIC Interest Rate
for Serial Bonds, continued
Calculate Bond Dollar Years
$10,000 x 1 = $10,000
9,000 x 1 =
9,000
8,000 x 1 =
8,000
6,000 x 1 =
6,000
3,000 x 1 =
3,000
Bond Year Dollars $36,000
Then the NIC is calculated as:
Total Interest (-premium+discount) $2,280
NIC = ---------------------------------------------- = ---------- = 6.333%
Bond Dollar Years
$36,000
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Calculating the TIC Interest Rate
for Serial Bonds
Par or
Coupon
Principal Rate
$1,000 x 3% =
1,000 x 4% =
2,000 x 5% =
3,000 x 6% =
3,000 x 7% =
Interest Payment
Principal Payment
Total Payment
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________Interest Paid at the End of___ _____
Year 1 Year 2 Year 3 Year 4 Year 5 Total
$ 30
$ 30
40
40
80
100
100
100
300
180
180
180
180
720
210
210
210
210
210
1,050
$560 $530
$490
$390
$210 $2,180
1,000 1,000 2,000 3,000 3,000 10,000
$1,560 $1,530 $2,490 $3,390 $3,210 $12,180
Calculating the TIC Interest Rate
for Serial Bonds, continued
Therefore, the TIC is the interest rate that makes:
$9,900 = (PV of $1,560, N=1) + (PV of $1,530, N=2) +
(PV of $2,490, N=3) + (PV of $3,390, N=4)
+ (PV of $3,210, N=5)
Using a spreadsheet program such as Excel®, this can be
solved using the IRR function. In Excel®, the solution
formula would be:
= IRR(values, guess)
= 6.347%
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Leases

Types of leases
Operating Leases: All short-term or cancelable leases
Capital Leases: Some long-term and non-cancelable leases

Possible advantages of Leasing
flexibility and protection against obsolescence
Bypass legal governmental debt requirements
equipment cost, and tax-related savings
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Possible disadvantages of leasing
 tendency toward higher costs

Capital lease obligations are valued at the PV of the
remaining future lease payments
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