Transcript Finance lease - WordPress.com

ANALYSIS OF FINANCING
LIABILITIES
FOCUS
• Understand the FS effects of issuing a bond at
par, at a discount, or at a premium.
• Calculate the book value of the bond and
interest expense at any point of time using the
effective interest rate method.
• Calculate the gain or loss from retiring a bond
before its maturity date
FINANCING LIABILITIES
• A bond is a contractual promise between a
borrower and a lender that obligates the bond
issuer to make payments to the bondholder
over the term of the bond.
• Two types: periodic interest payments,
repayment of principal at maturity.
• The face value: maturity value/ par value: the
amount of principal that will be paid to the
bondholder at maturity  used to calculate
the coupon payments.
• The coupon rate: the interest rate stated in
the bond  used to calculate the coupon
payments.
• The coupon payments: the periodic interest
payments to the bondholders.
• The effective rate of interest: interest rate
that equates the present value of the future
CF of the bond and the issue price.
• The balance sheet liability: equal to the
present value of its remaining CF, discounted
at the market rate of interest at issuance.
• The interest expense: is calculated by
multiplying the book value of the bond
liability at the beginning of the period by the
market rate of interest of the bond when it
was issued.
• The market rate = coupon rate  par bond
(priced at face value)
• Market rate > coupon rate  discount bond
(priced below par)
• Market rate < coupon rate  premium bond
(priced above par)
EXAMPLE: BOOK VALUES AND CF
• On Dec 31, 20X2, a company issued a 3 year,
10% annual coupon bond with a face value of
$100,000. Calculate the book value of the
bond at year – end 20X2, 20X3, 20X4 and the
interest expense for 20X3, 20X4 and 20X5,
assuming the bond was issue at a market rate
of interest of 10%, 9% and 11%
FS EFFECTS OF ISSUING A BOND
• Cash flow impact of issuing a bond
Cash flow from
financing
Cash flow from
operations
Issuance of debt
Increased by cash
received
No effect
Periodic interest
payments
No effect
Decreased by
interest paid
Payment at
maturity
Decreased by face
value
No effect
• Income statement impact of issuing a bond
Interest expense = market rate at issue x
balance sheet value of liability at
beginning of period
Issued at par
Issued at premium
Issued at a discount
Market rate = coupon
rate
Market rate < coupon
rate
Market rate > coupon
rate
Interest expense =
coupon rate x face
value = cash paid
Interest expense =
cash paid –
amortization of
premium
Interest expense =
cash paid +
amortization of
discount
Interest expense is
constant
Interest expense
decreases over time
Interest expense
increases over time
• Balance sheet impact of issuing a bond
Issued at par
Issued at a premium
Issued at a discount
Carried at face
value
Carried at face value
plus premium
Carried at face value
less discount
The liability decreases
as the premium is
amortized to interest
expense
The liability increases
as the discount is
amortized to interest
expense
THE ROLE OF DEBT COVENANTS IN
PROTECTING CREDITORS
• Debt covenant: restrictions imposed by the
lender on the borrower to protect the lender’s
position.
• Can reduce default risk and reduce borrowing
costs.
• The restrictions can be in the form of
affirmative covenants or negative covenants.
AFFIRMATIVE COVENANTS
• Make timely payments of principal and
interest
• Maintain certain ratios in accordance with
specified levels.
• Maintain collateral
NEGATIVE COVENANTS
• Increasing dividends or repurchasing shares.
• Issuing more debt.
• Engaging in mergers and acquisitions.
DISCLOSURES RELATING TO DEBT
• Balance sheet
• Footnote disclosure
The nature of the liabilities
Maturity dates
Stated and effective interest rates
Call provisions and conversion privileges
Restrictions imposed by creditors
Assets pledged as security
The amount of debt maturing in each of the next five
years
MOTIVATIONS FOR LEASING INSTEAD
OF PURCHASING THEM
• Finance lease:
 a purchase of an asset that is financed with debt.
 The lease will add equal amounts to both assets
and liabilities on the balance sheet,.
 the lease will recognize depreciation expense on
the asset and interest expense on the liability.
• Operating lease:
 Is essentially a rental arrangement
 Not asset or liability is reported by the lessee
 The
periodic
lease
payments
are
simply
recognized as rental expense in the income
statement.
CERTAIN BENEFIT FROM LEASING
•
•
•
•
•
Less costly financing
Reduced risk of obsolescence
Less restrictive provisions
Off balance sheet financing
Tax reporting advantages
DISTINGUISH FINANCE LEASE AND
OPERATING LEASE
• LESSEE’S PERSPECTIVE: require a lease to be
treated as a finance lease, include:
- Title to the leased asset is transferred to the
lessee at the end of the lease.
- The lease term covers a major portion of the
asset’s economic life (75% or more)
- The present value of the lease payment is 90%
or more of the fair value of the leased asset
• LESSOR’S PERSPECTIVE:
- Finance lease: all rights and risks of ownership
are transferred to the lease
- Operating lease: the lessor recognizes rental
income and continues to report and
depreciate the leased asset on its balance
sheet.
DETERMINE THE INITIAL
RECOGINITION AND MEASURMENT
• REPORTING BY THE LEASE:
- Operating lease:
the balance sheet is unaffected.
No asset or liability is reported by the lessee.
During the term of the lease, rent expense equal
to the lease payment is recognized in the lessee’s
income statement.
In the CFS, the lease payment is reported as an
outflow from operating activities
• Finance lease:
The lower of the present value of future minimum
lease payments or the fair value of the leased asset is
recognized as both an asset and liability on the
lessee’s balance sheet.
The asset is depreciated in the income statement and
interest expense is recognized.
Interest expense is equal to the lease liability at the
beginning of the period multiplied by the lease
interest rate
FS AND RATIO EFFECTS OF
OPERATING AND FINANCE LEASES
• Balance sheet:
- A finance lease results in a reported asset and a
liability.
- Turnover ratios that use total or fixed assets in their
denominators will be lower when a lease is treated
as a finance lease.
- ROA will also be lower for finance leases.
- Leverages ratio, debt to assets ratio, debt to equity
will be higher with finance leases then operating
leases.
• Income statement:
 EBIT will be higher for companies that use finance
leases relative to companies that use operating
leases.
 Operating lease: entire lease payment is an
operating expense
 Finance lease: only depreciation of the leased asset
is treated as an operating expense.
• Cash flow statement:
- Total cash flow is unaffected by the accounting
treatment of a lease.
- If the lease is treated as an operating lease 
the total cash payment reduces cash flow
from operations.
- If the lease is treated as a finance lease  the
portion of the lease payment that is
considered interest expense reduces CF from
operations.
FINANCE LEASE
OPERATING LEASE
Assets
Higher
Lower
Liabilities (current and
long term)
Higher
Lower
Net income (in the
early years)
Lower
Higher
Net income (later
years)
Total net income
Higher
Lower
Same
Same
EBIT (operating
income)
Higher
Lower
CF from operations
Higher
Lower
CF from financing
Lower
Higher
FINANCE LEASE
OPERATING LEASE
Current ratio
Lower
Higher
Working capital
Lower
Higher
Asset turnover
Lower
Higher
Return on assets
Lower
Higher
Return on equity
Lower
Higher
Debt/ Assets
Higher
Lower
Debt/ Equity
Higher
Lower