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Lecture Principles of financial accounting (2/e) - Chapter 14: Long-term liabilities

After completing chapter 14 you should be able to: Explain the types and payment patterns of notes, compare bond financing with shares financing, assess debt features and their implications, compute the debt-to-equity ratio and explain its use, prepare entries to record bond issuance and interest expense,. | Chapter 14 Long-Term Liabilities Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved Chapter 14: Long-Term Liabilities Bond Financing Bonds do not affect owner control. Interest on bonds is tax deductible. Bonds can increase return on equity. Advantages Bonds require payment of both periodic interest and par value at maturity. Bonds can decrease return on equity. Disadvantages A1 There are three main advantages of issuing bonds instead of shares. 1. Bonds do not affect owner control. Equity financing reflects ownership in a company, whereas bond financing does not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of all owner decisions. A person who owns a $1,000, 11%, 20-year bond has no ownership right. 2. Interest on bonds is tax deductible. Bond interest payments are tax deductible for the issuer, but equity payments to owners are not. 3. Bonds can increase return on equity. A company that earns a higher return | Chapter 14 Long-Term Liabilities Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved Chapter 14: Long-Term Liabilities Bond Financing Bonds do not affect owner control. Interest on bonds is tax deductible. Bonds can increase return on equity. Advantages Bonds require payment of both periodic interest and par value at maturity. Bonds can decrease return on equity. Disadvantages A1 There are three main advantages of issuing bonds instead of shares. 1. Bonds do not affect owner control. Equity financing reflects ownership in a company, whereas bond financing does not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of all owner decisions. A person who owns a $1,000, 11%, 20-year bond has no ownership right. 2. Interest on bonds is tax deductible. Bond interest payments are tax deductible for the issuer, but equity payments to owners are not. 3. Bonds can increase return on equity. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverage or trading on the equity. On the other side of the issue, there are two main disadvantages to issuing bonds. 1. Bonds require payment of both periodic interest and the par value at maturity. Bond payments can be especially burdensome when profit and cash flow are low. Equity financing, in contrast, does not require any payments because cash withdrawals (dividends) are paid at the discretion of the owner (or board of directors). 2. Bonds can decrease return on equity. When a company earns a lower return with the borrowed funds than it pays in interest, it decreases its return on equity. This downside risk of financial leverage is more likely to arise when a company has periods of low profit or net losses. A company must weigh the risks and returns of the disadvantages and advantages of bond financing when deciding whether to issue bonds to finance .