|
DEBT FINANCING |
|
|
Advantages |
Disadvantages |
|
Raises
capital |
Increases
liability |
|
No
change in ownership/management claims |
Payable
when due regardless of whether there is enough profit or cash flow |
|
No
dilution of profit sharing |
May be
too expensive if interest rate is high |
|
Tax
advantage: interest is deductible from Gross Income as an expense |
|
|
|
|
|
|
|
|
EQUITY FINANCING |
|
|
Advantages |
Disadvantages |
|
Raises
capital |
Dilutes
profit sharing |
|
No firm
commitment to repay principal |
May
increase voices in management |
|
No
commitment to pay profits if there are none |
Forgoes
tax advantages |
|
No
third party claim on assets of the firm |
|
The
following illustration shows the circumstances under which Debt or Equity
Financing is more advantageous for the individual investors. All scenarios are
based on the assumption that profits are shared equally among owners. There are
initially five owners in each case. The time-period involved is one year.
|
|
Scenario 1 Borrow $50 000 |
Scenario 2 Two new investors contribute |
Scenario 3 Borrow $50 000 |
|
Net
Income before interest expense and income tax |
$20 000 |
$20 000 |
$20 000 |
|
Interest
expense |
5000 |
0 |
10 000 |
|
Net
Income before income tax |
15 000 |
20 000 |
10 000 |
|
Income
tax (50%) |
7500 |
10 000 |
5000 |
|
Net
Income |
7500 |
10 000 |
5000 |
|
Earnings
per Investor |
$1500 |
$1429* |
$1000 |
|
|
|
|
|
* Rounded
to nearest full $. (10 000/7 investors)
Challenge:
Calculate the break-even interest rate.
Bond: long-term note that promises repayment of a specified amount borrowed
on a certain date (maturity date) and
regular periodic interest payments to bondholders in the meantime
Characteristics
·
Long-term
debt
·
Loans
obtained from a large number of lenders rather than one financial institution,
e.g., a bank.
·
A
single lender can provide different forms of financing, e.g., loan, bond.
·
Each
bond carries face or par value, e.g., the amount borrowed, printed on the
certificate
(usually $1000).
·
The
maturity date and the interest rate are clearly specified.
·
The
interest is calculated on the face value of the bond.
·
The
frequency of interest payments is clearly specified (usually semi-annually).
·
Bond
holders are a company’s creditors and have no ownership claims to profits.
·
Bond
interest must be paid before profits can be paid out. Bond interest is an
expense.
·
In
case a firm declares bankruptcy, bondholders are entitled to their claims
before owners.
Journal
entries for initial bond issue and half-yearly interest payment:
|
DATE |
PARTICULARS |
P.R. |
DEBIT |
CREDIT |
|
|
Mar. |
1 |
Bank |
|
800 000 |
|
|
|
|
Bonds Payable |
|
|
800 000 |
|
|
|
Issued
8% 15-year bonds |
|
|
|
|
|
|
|
|
|
|
|
Aug. |
31 |
Bond
interest expense |
|
32 000 |
|
|
|
|
Bank |
|
|
32 000 |
|
|
|
Paid
6-month interest on 8% bonds |
|
|
|
Journal
entries for the maturing bonds:
|
DATE |
PARTICULARS |
P.R. |
DEBIT |
CREDIT |
|
|
Mar. |
1 |
Bonds
Payable |
|
80 000 |
|
|
|
|
Bank |
|
|
80 000 |
|
|
|
Retired
8% 15-year bonds |
|
|
|
|
|
|
|
|
|
|
1. Based on your notes on debt versus equity
financing, set up a table that shows the advantages and disadvantages of bonds
as a means of financing.
|
Bond Financing |
|
|
Advantages |
Disadvantages |
|
(teacher
add rows) |
|
2. Based on your notes, create original
scenarios that demonstrate under what circumstances financing using bonds can be
more advantageous than attracting new investors. State your assumptions
clearly.
|
|
Scenario 1: |
Scenario 2: |
Scenario 3: |
|
(teacher
add 12 rows) |
|
|
|
3. Show the journal entries for an initial bond
sale of $100 000, 12%, 20-year bonds and their semi-annual interest payment.
The sale occurred on June 30.
|
DATE |
PARTICULARS |
P.R. |
DEBIT |
CREDIT |
|
|
Mar. |
1 |
Bank |
|
|
|
|
|
|
Bonds Payable |
|
|
|
|
|
|
Issued
8% 15-year bonds |
|
|
|
|
|
|
|
|
|
|
|
Aug. |
31 |
Bond
interest expense |
|
|
|
|
|
|
Bank |
|
|
|
|
|
|
Paid
6-month interest on 8% bonds |
|
|
|