Fae3e SM ch09

Chapter 9.
Debt Financing: Bonds, Notes and Leases
Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Difficulty Rating for Exercises and Problems:
Easy: E9.14; E9.15; E9.16

Medium: E9.17; E9.19; E9.20; E9.21; E9.24
P9.26; P9.27; P9.28; P9.31; P9.32; P9.33
Difficult: E9.18; E9.22; E9.23; E9.25
P9.29; P9.30; P9.34; P9.35; P9.36
QUESTIONS
Q9.1 Financing with Debt versus Equity. Debt financing is a cheaper form of
business financing because of the positive relationship between assumed risk
and expected reward this is, the more risk that is assumed, the higher the
expected rate of return on an investment. Since debtholders assume less risk
than equityholders, they are only entitled to a lower rate of return. Recall that
the creditors of a business have first claim on any assets of the firm, and thus,
in the event of bankruptcy, creditors are likely to get some (or all) of their
investment back. The same cannot be said for equityholders, who are likely to
lose everything in the event of a business failure.
Another reason that the cost of debt financing is less expensive relates to the
tax-deductibility of interest costs. The interest tax-shield effectively lowers the
ultimate cost of debt. There are no circumstances in which the cost of debt will
exceed, or even equal, the cost of equity.
Q9.2 Credit Ratings. Credit ratings determine the cost of borrowed funds and the
ease with which a firm is able to access those funds. Companies with an
investment grade rating pay less for their borrowed funds and generally have
more, and more readily accessible, sources of funds than do companies with
junk credit ratings.
When a company violates an existing debt covenant, the lender may exercise
its right to demand full and immediate payment of the borrowed amounts;
however, most lenders do not exercise that right and instead renegotiate the
terms of the debt contract. Renegotiated terms usually include an increase in
the cost of borrowing to reflect the borrowers increased financial riskiness and
possibly more restrictive debt covenants.
Cambridge Business Publishers, 2014

Solutions Manual, Chapter 9 9-1
Q9.3 Credit Ratings. A favorable credit rating is important to a company like General
Motors because it determines the cost that GM will have to pay for its borrowed
funds; it also determines the firms access to borrowed funds (i.e., companies
with an investment grade rating generally have greater access to lenders, as
well as access to a broader set of lenders, than do firms with a junk credit
rating).
Moodys decision to consider lowering the credit rating of GMACs debt makes
some sense in that the sale of Izusu Motors and the sale of a majority
shareholding in GMAC will benefit the liquidity of GM the automaker, but these
actions do not appear to improve the outlook for GMAC. A counterargument
can be made that a financially healthier GM means that GM will produce and
sell more autos, giving additional business to GMAC. Moodys apparently
doesnt buy into that argument (although Fitch and S&P do), as evidenced by
the statement that Moodys might further downgrade the GMAC debt.
Q9.4 Long-Term Debt Disclosures. Notes are usually secured debt financing (e.g.,
asset-backed) whereas debentures are most commonly unsecured (i.e.,
general obligation debt). Johnson and Johnson (J&J) will disclose $12,969
billion as noncurrent debt and $616 million as the current portion of long-term
debt. J&Js 3.8 percent debentures were sold at a slight discount as indicated
by the effective yield of 3.82 percent. Similarly, J&Js 6.95 percent notes were
sold at a discount given their effective yield of 7.14 percent. Finally, J&Js 6.73
percent debentures were sold at par given the effective yield of 6.73 percent.
Q9.5 Selling Bonds at a Discount, at Par, and at a Premium. When bonds are
sold into the capital market, a prospectus must be filed with the U.S. Securities
and Exchange Commission detailing various characteristics of the debt how
much is to be borrowed, for what purpose, how will the funds be repaid and
when, and the coupon rate on the bonds. What is not known about a bond prior
to its sale is its yield rate, or its real cost of capital. Since the coupon rate is part
of the SEC prospectus filing, it is often specified weeks in advance of the actual
bond sale; and thus, it is quite likely that the coupon rate specified in the
prospectus will not equal the bonds actual yield rate on the date of sale. When
this happens, the bond will sell for a premium or discount. In general, if the:
Coupon rate exceeds the yield rate, a bond will sell for a premium.
Coupon rate is less than yield rate, a bond will sell for at a discount.
Coupon rate is equal to the yield rate, a bond will sell at its par value.

9-2 Financial Accounting for Executives & MBAs, 3 rd Edition
Q9.6 Accounting for Bonds at a Constant Yield Rate. When bonds are sold into
the capital market, they are sold at a market rate of interest reflecting the
riskiness of the bond. For accounting purposes, the issued bonds are recorded
on the balance sheet at their sale price, which reflects the market yield rate at
the time of sale. Since companies are assumed to hold such debt instruments
until maturity, the daily changes in a bonds market yield rate, and thus, the
daily changes in a bonds fair market value, are ignored for accounting
purposes. The bonds are carried on the balance sheet of the issuing company
at a constant yield rate, specifically the yield rate on the date of sale. As a
consequence, the value of a companys debt may be over- or understated
relative to its current fair value. And, thus, a firms total debt may be over- or
understated relative to the amount would be required to retire the debt.
Although it would certainly be possible to mark all debt instruments to fair

market value, the offsetting financial effect would have to be taken to Other
Comprehensive Income, similar to what is done with available-for-sale
securities. It is unclear whether this alternative accounting would be useful to
financial statement users.
Q9.7 Why Do Companies Lease? There are a variety of reasons why businesses
use leasing as a financing option:
1. Leasing is often cheaper than other forms of debt financing.
2. Leasing often involves less restrictive debt covenants than does bank
financing.
3. Leasing avoids locking into assets that may become technologically
obsolete.
4. Leasing (if involving operating leases) may be used as off-balance
sheet financing, and thus, have certain financial reporting benefits.
5. Leasing may require smaller up-front capital (i.e., down payment) than
other forms of debt financing.
6. Leasing may be readily available to companies lacking the credit rating
to obtain traditional forms of debt financing.
Q9.8 Operating Leases and Market Efficiency. Available empirical research in

finance and accounting suggests that the capital market is indeed efficient with
respect to operating leases. That is, available evidence suggests that the
capital markets treat operating leases equivalently to on-balance-sheet debt for
purposes of valuing a company and when assessing its credit risk.
Nonetheless, the demand for operating-lease financing remains high because
many managers believe that the capital markets are inefficient with respect to
operating leases.

Q9.9 Zero-Coupon Convertible Debentures. Zero-coupon debentures require no
periodic cash interest payments, and instead, any unpaid interest is added to
the principal value of the debenture. Thus, if a company has limited cash to
service its debt, zero-coupon debentures present an opportunity for a company
to raise debt financing without incurring the current cost of debt servicing.
Since the debentures were convertible into Johnson & Johnson common stock,
when the J&J share price raises above the conversion price ($40.102), there
may be a financial incentive for the debenture-holders to convert their zero-
coupon debentures into J&J stock, especially if the dividend yield on the stock
exceeds the implicit yield on the bonds. In short, the bonds could be completely
cash-free no cash debt servicing on the debt and no cash repurchase.
Given a 20 year maturity, assuming semiannual compounding, the debentures

were sold at an effective yield of:
PV = FV x PV factor (n-40, i-?)

$551.26 = $1,000 x PV factor
PV factor = .55126
i = 1.5% per period or 3% per year
Q9.10 Converting Notes Payable into Common Stock. The US Airways notes have
a cash value of only $1,050 if redeemed, but a share value of over $1,200 if
converted into the companys common stock:
$36 per share x 34.376 shares = $1,237.54
Thus, a rational investor would prefer the greater economic value provided by
the common shares, which can be sold, to the lower redemption cash value.
Since the US Airways notes paid interest of 7.5 percent, and the companys
common stock paid no cash dividend, the noteholders had no incentive to
convert their notes prior to being called by the firm in 2006.
Converting the notes into common stock means that US Airways will no longer
have to make the regular debt service payments on the notes. Thus, net
income will be improved and operating cash flow is protected. The downside to
the conversion is that the company has converted a cheap form of financing
into a more expensive form of financing.

Q9.11 Collateralized Debt Obligations. Collateralized debt obligations (CDOs), or
real estate bonds, represent an ownership interest in a pool of real estate loans
and mortgages that are secured (or collateralized) by commercial real estate
such as a shopping center, office building, or hotel. Most of the real estate
CDOs sold in the U.S. have been sold by real estate investment trusts (REITs).
REITs buy revenue-producing real estate and/or income-producing real estate
loans and mortgages. The REITs then issue bonds (CDOs) that are backed by
the loans and mortgages. In short, the CDOs provide the REITs with another
means to lever themselves (i.e., to raise debt capital) and finance additional
real estate investments.
Q9.12 Debt-for-Equity Exchange. The market value of the UAL common shares was
$4.485 billion (115 million shares x $39 per share), and the book value of the
debt was $28.485 billion ($24 billion + $4.485 billion). Thus, the financial effects
of the debt-for-equity swap can be summarized as follows:
Account Amount, Effect
Bonds payable Decline by $28.485 billion

Common stock Increase by $4.485 billion
Gain on exchange Increase by $24.0 billion
(Retained earnings)
This transaction reveals that UALs creditors received about $0.16 in value for
each $1.00 in debt. But, immediately following the announcement, UALs share
price fell to $35.50, or about nine percent, to reflect the dilutive effect of the
debt-for-equity exchange. Thus, the value received by creditors declined
another $0.014 per $1.00 of debt following the announcement.

Q9.13 (Ethics Perspective) Avoiding the Recording of Leases on Balance Sheet.
One of the universal truths in financial reporting is that avoiding the recording of
debt is an advisable strategy. Numerous opportunities for off-balance-sheet
financing exist, including the use of the equity method for investments and
leasing. Leasing disclosure rules, however, require sufficient information in the
footnotes to allow a financial statement user to easily determine the effect of
the lease on the firms financial condition.
This begs the question of why is there a strong desire among managers to
account for leases as operating rather than capital leases? One potential
reason is that managers do not believe that disclosure carries the same impact
as actual recognition on the financial statement. A similar reason appears to be
behind the strong resistance to the expensing of employee stock option
expense. A second reason behind the desire to keep leases off-balance-sheet
could be the wish to maintain more desirable ratios. Many contracts such as
debt covenants and possibly compensation contracts are often tied to reported
accounting numbers. Finally, rating agencies often utilize reported financial
ratios in their determination of debt ratings.
The question of whether it is ethical to choose a particular accounting treatment

for purely reporting reasons is not an easy one to answer. It has its roots in the
debate regarding whether earnings management represents an ethical breach.
Most will argue that earnings management for purely personal gain represents
an ethical breach. It is less clear whether earnings management to benefit the
firm, be it a higher debt rating or avoiding a technical default, represents an
ethical breach. This same dilemma was previously explored in the ethics
questions from chapters three and seven.

EXERCISES
E9.14 Coupon Rates, Yield Rates, and Bond Issuance Prices.

Bond Sold At
A Discount
B Premium
C Par value
D Premium
E Discount
E9.15 Calculating Bond Issuance Prices.

Bond Issue Price (per $1,000)**
A [$20 x PV(3%, 10) + $1,000 PV(3%, 10)] = $170.60 + $744.00 = $914.60
B [$50 x PV(4%, 12) + $1,000 x PV(4%, 12)] = $469.25 + $625.00 = $1,094.25
C [$30 x PV(3%, 20) + $1,000 x PV(3%, 20)] = $446.31 + $554.00 = $1,000.31*
D [$0 x PV(4%, 30) + $1,000x PV(4%, 30)] = $0 + $308.00 = $308.00
E [$40 x PV(5%, 20) + $1,000 x PV(5%, 20)] = $498.48 + $377.00 = $875.48
* rounding difference
** The first PV is for an ordinary annuity; the second PV is for a lump sum.
E9.16 Bond Discounts and Effective Interest Rates.

Effective interest rate:
$182.56 million = $400 million x PV factor
PV factor = $182.56 $400 = .4564
i = 4.0% or 8% annual rate
Interest expense:
1st six months: $182.56 x 0.04 = $7.3024 million
2nd six months: $189.86 x 0.04 = $7.5945 million
Total $14.8969 million

E9.17 Calculating the Fair Value of Debt.
Proceeds from sale of the notes:
$1,500,000 x PV (4%, 10) = $1,500,000 x 8.111 = $12,166,500
+ $50,000,000 x PV (4%, 10) = $50,000,000 x 0.676 = $33,800,000
Proceeds $45,966,500
Balance sheet disclosure (following issuance):

Notes payable $50,000,000
Less Discount (4,033,500)
Note payable (net) $45,966,500
Interest expense:
First six months:
4% x $45,966,500 = $1,838,660
Second six months
4% x ($45,966,500 + $338,660) = $1,852,206
Total $3,690,866
Balance sheet value (end of year 1):

Discount amortization:
First six months $338,660
Second six months 352,206
Total $690,866
Discount at end of year = $4,033,500 - $690,866 = $3,342,634
Balance sheet disclosure (year-end):

Notes payable $50,000,000
Less: Discount (3,342,634)
Notes payable (net) $46,657,366

E9.18 Building a Note Amortization Table.
Valcor, Inc.
4% Note Amortization Table
(1) (2) (3) (4) (5)
Book Value Interest Cash Discount Note
Period of Notes Expense Payment Amortization Discount
BOP $94,582,380 1) $5,417,620
EOP (1) $95,419,851 5) $2,837,471 2)
$2,000,000 $837,471 3)
$4,580,149 4)
EOP (2) 96,282,447 2,862,596 $2,000,000 862,596 3,717,553
EOP (3) 97,170,920 2,888,473 $2,000,000 888,473 2,829,080
EOP (4) 98,086,048 2,915,128 $2,000,000 915,128 1,913,952
EOP (5) 99,028,629 2,942,581 $2,000,000 942,581 971,371
EOP (6) 99,999,949 6) 2,970,859 $2,000,000 970,859 512 6)
$12,000,000
1. [($100,000,000 x 0.837) + ($2,000,000 x 5.417)] = $94,582,380.

2 ($94,582,380 x .03) = $2,837,471
3. ($2,837,471 - $2,000,000) = $837,471
4. ($5,417,620 - $837,471) = $4,580,149
5. ($94,582,380 + $837,471) = $95,419,851
6. Rounding error
$100,000,000 x 0.837 = $83,700,000

+ $2,000,000 x 5.417 = $10,834,000
$94,534,000
E9.19 Accounting for Bonds Sold at a Discount.

Proceeds:
Periodic cash interest payment = $100,000,000 x 0.04 = $4,000,000
$4,000,000 PV(5%, 20) = $4,000,000 x 12.462 = $49,848,000

$100,000,000 PV(5%, 20) = $100,000,000 x 0.377 = 37,700,000
$87,548,000
Balance sheet disclosure (following sale):

Bonds payable $100,000,000
Less: Bonds discount (12,452,000)
Bonds payable(net) $87,548,000
Continued next page

Continued
Interest expense:
First six months:
$87,548,000 x 0.05 = $4,377,400
Second six months
($87,548,000 + $377,400) x 0.05 = 4,396,270
Total $8,773,670
Balance sheet disclosure (end of year 1):

Discount amortization:
Total $773,670
Bond discount (end of year 1)

Bond discount $12,452,000
Less: Amortization (773,670)
Bond discount $11,678,330

Less: Bond discount (11,678,330)
Bonds payable (net) $88,321,670
E9.20 Market Yield Rates and Bond Values.

Proceeds from sale of the bonds:
Periodic cash interest = $80,000,000 x 0.03 = $2,400,000
payment
$2,400,000 x PV(4%, 10) = $2,400,000 x 8.111 = $19,466,400

$80,000,000 x PV(4%, 10) = $80,000,000 x 0.676 = 54,080,000
Total proceeds $73,546,400
Book value after one year:

$2,400,000 x PV(4%, 8) = $2,400,000 x 6.733 = $16,159,200
$80,000,000 x PV(4%, 8) = $80,000,000 x 0.731 = 58,480,000
Book value $74,639,200
Book value after two years:

$2,400,000 x PV(4%, 6) = $2,400,000 x 5.242 = $12,580,800
$80,000,000 x PV(4%, 6) = $80,000,000 x 0.790 = 63,200,000

Continued next page

Continued
Market value after one year:

$2,400,000 x PV(5%, 8) = $2,400,000 x 6.463 = $15,511,200
$80,000,000 x PV(5%, 8) = $80,000,000 x 0.679 = 54,160,000
Market value $69,671,200
Market value after two years:

$2,400,000 x PV(2%, 6) = $2,400,000 x 5.601 = $13,442,400
$80,000,000 x PV(2%, 6) = $80,000,000 x 0.888 = 71,040,000
The relationship between market yield rates and market prices of fixed-rate
securities is an inverse one. Notice that at the end of year one, when the
market yield rate moved up to ten percent, the market price of the bonds fell
to $69.7 million; but, at the end of year two, when the market yield rate fell
to four percent, the market value of the bonds rose to $84.5 million.
E9.21 Accounting for Notes Issued at a Premium.

Proceeds from sale of notes:
$2,000,000 x PV(3%, 10) = $2,000,000 x 8.530 = $17,060,000
$50,000,000 x PV(3%, 10) = $50,000,000 x 0.744 = 37,200,000
Proceeds $54,260,000
The bonds would be sold for a premium of $4,260,000.
Balance sheet:
Plus: Bond premium 4,260,000
Interest expense:
First six months:
$54,260,000 x 0.03 = $1,627,800
Second six months
($54,260,000 $372,200) x .03 = 1,616,634
Total $3,244,434
Continued next page

Continued
Book value at end of first year:

Premium amortization:
Total $755,566
Book value of premium: = $4,260,000 - $755,566 = $3,504,434
Balance sheet:
Plus: Bond premium 3,504,434
Bonds payable (net) $53,504,434
E9.22 Issuing Zero-Coupon Bonds.

Yield rate at time of issuance
Yield rate = 1.5 percent (3% semi-annually)
$551.26 = $1,000 x PV(x%, 40)
0.55126 = PV(x%, 40)
ALZA Corporation is a biotechnology company with significant cash flow

needs to fund R&D. The use of zero-coupon bonds allows the company to
raise debt capital without the requirement of periodically servicing the debt,
and thus, to devote greater amounts of its available cash flow to its R&D
efforts.
ALZA Corporation attached a conversion feature to the zero-coupon

debentures for two reasons:
1. Since the conversion feature has potential value, it lowers
ALZAs overall cost of debt financing.
2. If ALZAs common share price rises sufficiently, bondholders
may exercise the stock conversion feature and ALZA will avoid the
cash drain associated with debt repayment.
Implicit interest expense (per $1,000 bond):

First six months:
$551.26 x 0.015 = $8.2689
($551.26 + $8.2689) x 0.015 = 8.3929
Total $16.66 per bond

E9.23 Retiring Debt Early.
Book value of debt after two years:
$2,400,000 x PV(4%, 6) = $2,400,000 x 5.242 = $12,580,800

$80,000,000 x PV(4%, 6) = $80,000,000 x 0.790 = 63,200,000
Market value of debt after two years:

$2,400,000 x PV(5%, 6) = $2,400,000 x 5.076 = $12,182,400
$80,000,000 x PV(5%, 6) = $80,000,000 x 0.746 = 59,680,000
Gain on early retirement:

Book value of bonds $75,780,800
Repurchase price (71,862,400)
Gain $3,918,400
So long as Smith & Company doesnt need the financing, early retirement
makes sense. But if the company needs the financing, it will effectively
replace cheaper debt with more expensive debt.
E9.24 Operating Leases.

Present value of the companys operating lease payments
Lease PV Factor
Year Payment (i = 8%) PV
2006 $162 0.926 $150.01
2007 142 0.857 121.69
2008 119 0.794 94.49
2009 103 0.735 75.71
2010 88 0.681 59.93
2011 88* 0.630 55.44
2012 63* 0.583 36.73
Total 765 $594.00
* We assume that any thereafter amount is straight-lined over the remaining years using
the lease payment of the 5th year (2010), with the final year (2012) lease payment a plug
figure to balance to the total future minimum lease payment ($765).
Long-term debt-to-equity ratio after capitalization of operating leases:

(2,565 + 594)/31,813 = 9.9% - 8.1% = 1.8% change.

E9.25 Capitalizing Operating Leases.
Present value of Delta Airlines, Inc. operating leases (in millions)
Minimum
Year Lease Payment* PV Factor PV
2013 $1,507 0.952 $1,434.66
2014 1,433 0.907 1,299.73
2015 1,332 0.864 1,150.85
2016 1,159 0.823 953.86
2017 1,000 0.784 784.00
2018 1,000 0.746 746.00
2019 1,000 0.711 711.00
2020 1,000 0.677 677.00
2021 1,000 0.645 645.00
2022 1,000 0.614 614.00
2023 1,000 0.585 585.00
2024 1,000 0.557 557.00
2025 415 0.530 219.95
Total $13,846 $10,378.05
* We assume that any thereafter amount is straight-lined over the remaining lease
period (2018 2025) using the lease payment of the 5 th year (2017), with the final lease
payment a plug ($415) to balance to the total future minimum lease payments ($13,846).
Ratios
Without Operating With Operating
Lease Capitalization Lease Capitalization
Total debt to total assets 1.05 1.04
Failure to consider a firms use of operating leases understates the

assessment of financial risk as the above ratios reveal, although not
significant in this case.

PROBLEMS
P9.26 Debt Valuation: Interest-Bearing Debentures

1. Proceeds from sale of the bonds
Present value of $100 million in 40 periods @ 6%: $ 9,700,000
+ Present value of an annuity of $4 million per period for
40 periods @ 6%: 60,184,000
$69,884,000
2. Since the debt market is currently demanding a return of six percent

per period, while the Global Minds bonds are only paying a coupon rate of
four percent semiannually, potential investors must be compensated for the
loss of two percent in their expected return. Lowering the purchase price of
the bonds by $30.116 million will enable the purchaser to earn an effective
rate of return to maturity of six percent per period. The discount of $30.116
million is the present value of $2 million per period for 40 periods at a yield
rate of six percent per period.
3. Market value of bonds after ten years at ten percent:

Present value of $100 million in 20 periods @ 10%: $14,900,000
20 periods @ 10%: 34,056,000
$48,956,000
4. Market value of bonds after 15 years at ten percent:

10 periods @ 10%: 24,580,000
$63,180,000
Book value of bonds after 15 years at six percent:

10 periods @ 6%: 29,440,000
$85,240,000
Continued next page

4. Continued
Financial effects of early debt retirement:

Bonds payable decline by $100 million
Bond discount declines by $14.76 million
Cash declines by $63.18 million
Gain on early retirement increases by $22.06 million
The gain on early retirement should be subtracted from cash flow from
operations, and the cash outflow to retire the debt should be reported as
part of the cash flow for financing.
P9.27 Debt Valuation: Zero-Coupon Debentures

1. Proceeds = $17.4 million (i.e., the present value of $100 million in 30
periods @ 6%). The financial effect of the issuance:
Cash increases by $17.4 million
Bond discount increases by $82.6 million
Bonds payable increases by $100 million
2. Repurchase of Bonds
Book value of bonds:
Present value of $100 million in 20 periods at 6%: $31.2 million
Market value of bonds:

Present value of $100 million in 20 periods at 8%: $21.5 million
Financial effects of retirement:

Bonds payable decline by $100 million
Bond discount declines by $68.8 million
Cash declines by $21.5 million
Gain on early retirement increases by $9.7 million
The early retirement of this debt results in the recognition of a gain of $9.7
million. The decision appears to be a good one only if KMF, Inc. no longer
needs this long-term financing. To retire the zero-coupon bonds which only
cost six percent semiannually would be unwise if additional debt costing
eight percent per period were then issued.
3. Zero-coupon bonds provide a company with insufficient cash flows to

service its debt financing with a means to finance its operations or capital
investments that would not otherwise be possible with regular interest-
bearing debt.
P9.28 Debt Retirement.
1. The proceeds received by MTF, Inc. at issuance of $100 million, ten year,
eight percent bonds (yield = six percent) would be calculated as follows:
Present value of maturity value ($100 million x 0.558) $55,800,000

Present value of interest annuity ($8 million x 7.360)
(annual interest payment: 0.08 x $100,000 million = $8 million) 58,880,000
Total proceeds $114,680,000
2. The interest expense for the first two years would be:
Interest expense = Bond liability x Yield rate.
Year One: $114,680,000 x 0.06 = $6,880,800
The bond carrying value at the end of year one is:
Bond payable $100,000,000

+ Bond premium 13,560,800
Bond liability $113,560,800
Year Two: $113,560,800 x 0.06 = $6,813,648
The bond carrying value at the end of year two is:
Bond payable $100,000,000

+ Bond premium 12,374,448
Bond liability $112,374,448
3. The amount of cash needed to retire the debt after two years, assuming no
transaction costs and a yield rate of twelve percent, would be:
Present value of maturity value in 8 years
($100 million x 0.404): $40,400,000
Present value of interest annuity for 8 years
($8 million x 4.968): 39,744,000
Cash needed: $80,144,000
Financial effects of the early retirement:

Bonds payable decreases by $100 million
Bond premium decreases by $12,374,448
Cash decreases by $80,144,000
Gain on early retirement increases by $32,230,448
The gain on early retirement should be subtracted from cash flow from
operations, and the cash outflow to retire the debt should be reported as
part of the cash flow for financing.

P9.29 Note Valuation
1. The notes were sold at a discount since the stated rate of 2.950% is less
than the effective rate of 3.049%
2. $866,417 million [(0.544x1,000,000)+(14.877x(0.021*1,000,000))]

(n=20, rate=3.0%)
3. a. Higher
b. Lower
4. A loss since the book value of the notes is less than the face value of
$1,750 (since the stated rate is less than the effective rate).
P9.30 Note Valuation

1. a. Face value appears on balance sheet, indicating issued at par.
b. $17.25 million ($600 million x 5.75% x )
c. Proceeds = $596.92 million
[PV(4, 3%) x $17.25 million + PV(4, 3%) x $600 million]
2. a. Lower
b. Higher
c. Loss of $96 million
d. The long-term debt-to-equity ratio was lower in 2011 and the interest
coverage ratio higher; hence, the rating would have been higher.
2012 2011
(without $600 million
of 5.75% notes issued)
Long-term debt to equity (2,900.70-600.00)/ 1,540.40/3,481.20
(Assumes tax rate of 40%) (3,916.60+31.63*(1-.4)
= 0.58 =0.44
Interest coverage 523.20/(253.00-31.63) 1,089.40/255.30

(operating income/interest expense)
= 2.36 = 4.27
Interest expense on 5.75% notes

for Feb. 1, 2004 through Dec. 31,
2012 = 600*5.75%*11/12=$31.63
Assumes no change in operating

income

P9.31 Valuing a Lease.
1. A leased asset and a lease liability will be capitalized to the KMF, Inc.
balance sheet in the amount of $293,400, the present value of an annuity
(in advance) of $50,000 per year for eight years at ten percent. The lease
liability, however, is immediately reduced by the first lease payment of
$50,000, to $243,400, equivalent to the present value of $50,000 per period
for seven periods at ten percent.
2. At the beginning of the second year, the lease payment of $50,000 is

divided as follows:
Reduction in lease liability: $25,660
Interest expense: $24,340(10% x $243,400)
At the beginning of the third year, the lease payment of $50,000 is divided
as follows:
Reduction in lease liability: $28,226
Interest expense: $21,774 (10% x $217,740)
In both years, depreciation in the amount of $36,675 (i.e., $293,400 8

years) would be recorded.
3. Over the life of the lease, the total deductions taken will aggregate to
$400,000 (8 x $50,000), regardless of which lease accounting treatment is
adopted. However, the expense deductions will be greatest in the early
years of the lease agreement if the lease is accounted for as a capital lease.
Thus, when considering the time value of money, there is some advantage
to adopting the capital lease treatment.

P9.32 Lease Accounting.
1. $14.9 million
$100 million = X [PV(10, 8%)]
X = 6.71
$100 million 6.71 = $14.9 million
2. A leased asset and a lease liability in the amount of $100 million will be
capitalized to the balance sheet.
3.
Item Financial Effect
Cash Decrease by $14.9 million

Interest expense Increase by $8 million ($100 million x 8%)
Lease obligation Decrease by $6.9 million
Depreciation expense Increase by $10 million ($100 million 10 yrs)

Accumulated depreciation Increase by $10 million
4.
Operating Capital
Expense Item Lease Lease
Rent expense 14.90 --
Interest expense ($100-$6.90]*8% -- 7.45
Amortization expense -- 10.00
Total 14.90 17.45

P9.33 Lease Accounting.
1. $22.02 million
$150 million = X [PV(15, 12%)]
X = 6.811
$150 million 6.811 = $22.02 million
2. A leased asset and a lease liability in the amount of $150 million will be
capitalized to the balance sheet.
3.
Item Financial Effect
Cash $22.02 million
Interest expense $18 million (12% x $150 million)
Lease obligation $4.02 million ($22.02 $18.00)
Depreciation expense $10 million ($150 million 15 years)
Accumulated depreciation $10 million
4.
Operating Capital
Expense Item Lease Lease
Rent expense 22.02 --
Interest expense ($150-$4.02)*12% -- 17.52
Amortization expense -- 10.00
Total 22.02 27.52

P9.34 Capitalizing Operating Leases.
1. Present value of operating leases (i = 6%):
Lease Present Value Present
Date Payment* Factor (i = 6) Value
2012 $1,247.00 0.943 $1,175.92
2013 1,167.60 0.890 1,039.16
2014 1,074.90 0.840 902.92
2015 965.00 0.792 764.28
2016 851.80 0.747 636.29
2017 851.80 0.705 600.52
2018 851.80 0.665 566.45
2019 851.80 0.627 534.08
2020 851.80 0.592 504.27
2021 851.80 0.558 475.30
2022 851.80 0.527 448.90
2023 851.80 0.497 423.34
2024 285.30 0.469 133.81
Total $11,554.20 $8,205.24
* Assumes any thereafter amount is straight-lined over the remaining lease period using the 5 th
year (2016) lease payment, with the final year amount a plug figure to reconcile to the total future
minimum lease payments ($11,554.20).
2. Restated balance sheet

2011
Assets
Current assets $4,403.00
Noncurrent assets ($28,586.90 + $8,205.24) 36,792.14
Total assets $41,195.14
Liabilities & Shareholders Equity
Current liabilities ($3,509.20 + $1,175.92) $4,685.12
Long-term debt ($12,133.80 + $7,029.32) 19,163.12
Other noncurrent liabilities 2,956.70
Shareholders equity 14,390.20
Total liabilities & shareholders equity $41,195.14
3. Ratios
2011
Without Operating With Operating
Lease Capitalization Lease Capitalization
Long-term debt to shareholders equity 84.3% 133.2%
Total debt to total assets 56.4% 65.1%
This question is an excellent time to introduce or illustrate the concept of

market efficiency. Because the data regarding the operating leases were
publicly available, one can assume that the impact of these obligations
would be fully reflected in the companys debt rating.

CORPORATE ANALYSIS
CA9.35 The Procter and Gamble Company.
a. 2012 2011
Total debt-to-total assets 51.6% 50.8%
P&G is principally debt financed, although the absolute amount of debt

declined from 2011 to 2012 ($70.353 billion to $68.209 billion) the use of
debt financing actually increased by 0.8% from 2011 to 2012, due to a
decrease of $6.110 billion in total assets over the same time period.
2012 2011
Weighted-average cost of debt
Short-term 0.6% 0.9%
Long-term 3.3% 3.4%
P&Gs short-term cost of debt decreased by a third, while its long-term

cost of borrowing remained almost flat.
b. 2012 2011
Return on assets-levered 8.1% 8.5%
Credit rating Short-term Long-term
Moodys (Source: Moodys) P-1 Aa3
S&Ps (Source: S&Ps) A-1+ AA-
P&Gs return on assets exceeds eight percent in both 2012 and 2011
Given that the companys spread between its ROA and pre-tax cost of
borrowing is about five percent, using leverage to finance its operations
and asset growth makes good sense. The companys short-term and
long-term credit ratings are both investment grade.
Continued next page

Continued
c. P&G defines its total debt to be long-term debt ($21.080 billion) plus
debt due within one year ($8.698 billion). Footnote 4 provides a
specific description of each category.
Long-term debt is mainly composed of notes and debentures,
issued in a variety of currencies (i.e., USD, EUR, JPY, GBP), at a
variety of rates (i.e., floating rate, 0.7% to 9.36%), and with various
maturity dates (i.e., 2014 to 2037).
Debt due within one year is mainly composed of commercial paper
and the current portion of long-term debt.
P&Gs decision to issue notes in a variety of currencies was most likely
undertaken to access favorable borrowing rates in those countries
where the company maintains operations, as well as to create a natural
hedge against currency fluctuations between the U.S. dollar and the
British pound, EU euro, and the Japanese yen. P&G did not reveal that
it is subject to any debt covenants.
d. Footnote 10 reveals that P&G uses operating leases to finance certain

property and equipment, for varying periods and has future minimum
rental commitments under non-cancelable operating leases, net of
guaranteed sublease income, of: (in millions):
Present
PV (4%) Value
2013 $289 0.962 $278.02
2014 263 0.925 243.28
2015 235 0.889 208.92
2016 223 0.855 190.67
2017 170 0.822 139.74
Total $1,180 $1,060.63
P&G uses operating leases ($1,060.63) more extensively than capital

leases ($45), but relative to the companys total debt of $29.78 billion in
2012, operating leases constitute only about 3.6 percent of the firms
total debt. In short, P&Gs use of lease financing is not material.

CA9.36.Internet-based Analysis. No solution is provided as any solution would be
unique to the company selected.
CA9.37 IFRS Financial Statements. LVMH Moet Hennessey-Louis Vuitton S.A.

(EUR millions) 2012 2011
Long term and short term borrowings 6,812 7,266
Equity 25,666 23,512
Ratio of total debt to total equity 26.5% 30.9%
The ratio of total borrowings, which was 30.9% as of December 31, 2011, fell
4.4 points to 26.5%. This favorable change was due mainly to a 2.1 billion euro
increase in equity, but also to a 0.4 billion euro reduction in net financial debt.
LVHM is principally equity financed.


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Chapter 9.

Debt Financing: Bonds, Notes and Leases

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Easy: E9.14; E9.15; E9.16

Cambridge Business Publishers, 2014

Cambridge Business Publishers, 2014

Although it would certainly be possible to mark all debt instruments to fair

Q9.8 Operating Leases and Market Efficiency. Available empirical research in

Cambridge Business Publishers, 2014

Given a 20 year maturity, assuming semiannual compounding, the debentures

PV = FV x PV factor (n-40, i-?)

$36 per share x 34.376 shares = $1,237.54

Cambridge Business Publishers, 2014

Account Amount, Effect

Bonds payable Decline by $28.485 billion

Cambridge Business Publishers, 2014

The question of whether it is ethical to choose a particular accounting treatment

Cambridge Business Publishers, 2014

E9.14 Coupon Rates, Yield Rates, and Bond Issuance Prices.

E9.15 Calculating Bond Issuance Prices.

E9.16 Bond Discounts and Effective Interest Rates.

Cambridge Business Publishers, 2014

Balance sheet disclosure (following issuance):

Balance sheet value (end of year 1):

Discount at end of year = $4,033,500 - $690,866 = $3,342,634

Balance sheet disclosure (year-end):

Cambridge Business Publishers, 2014

1. [($100,000,000 x 0.837) + ($2,000,000 x 5.417)] = $94,582,380.

$100,000,000 x 0.837 = $83,700,000

E9.19 Accounting for Bonds Sold at a Discount.

$4,000,000 PV(5%, 20) = $4,000,000 x 12.462 = $49,848,000

Balance sheet disclosure (following sale):

Continued next page

Cambridge Business Publishers, 2014

Balance sheet disclosure (end of year 1):

Bond discount (end of year 1)

Bonds payable $100,000,000

E9.20 Market Yield Rates and Bond Values.

$2,400,000 x PV(4%, 10) = $2,400,000 x 8.111 = $19,466,400

Book value after one year:

Book value after two years:

Cambridge Business Publishers, 2014

Cambridge Business Publishers, 2014

Market value after one year:

Market value after two years:

E9.21 Accounting for Notes Issued at a Premium.

The bonds would be sold for a premium of $4,260,000.

Continued next page

Cambridge Business Publishers, 2014

Book value at end of first year:

Book value of premium: = $4,260,000 - $755,566 = $3,504,434

E9.22 Issuing Zero-Coupon Bonds.

ALZA Corporation is a biotechnology company with significant cash flow

ALZA Corporation attached a conversion feature to the zero-coupon

Implicit interest expense (per $1,000 bond):

Cambridge Business Publishers, 2014

$2,400,000 x PV(4%, 6) = $2,400,000 x 5.242 = $12,580,800

Market value of debt after two years:

Gain on early retirement:

E9.24 Operating Leases.

Long-term debt-to-equity ratio after capitalization of operating leases:

Cambridge Business Publishers, 2014

Failure to consider a firms use of operating leases understates the