In addition to raising capital from stock issuance, many companies issue debt securities in the form of bonds to finance their operations. In the issuance of new bonds, a company has options with respect to how to place the bonds in the market. These options are as follows:
1. Competitive Bids
Competitive bids are the process by which the bond issuer solicits bids from the underwriting of various investment banks. This is typically used when dealing with municipal bonds.
2. Negotiated Sales
A negotiated sale is the process whereby a bond issuer negotiates with the investment bank with respect to the pricing of underwriting services.
3. Private Placements
A private placement is the process whereby an investment bank "places" the new bond issue with a small number of buyers, typically large institutions. Private placements are not registered with the SEC for public sale.
Three Types of Coupons
A bond is essentially an IOU or promise to pay a predetermined annual or semiannual interest payment and to pay back the principal (face value) when the bond matures. When a company issues a bond with coupon payments that are equal to the current market rate, the bond is said to be issued at par. From an accounting point of view this means that if a company issues a $1M bond at par the company will in return have raised $1M in capital for its efforts.
When bonds are issued with coupon payments that are not equal to the current market interest rate they are considered to be issued at a "premium" or "discount" to or from par. Companies that are very active in bond issuance issue bonds at par more frequently than those companies that are not as active.
Example of bonds issued at a discount:
Company ABC issues a bond that will pay 9% a year for five years and similar bonds trading are currently paying 10%.While there are multiple market related factors that determine the issuing price (supply and demand, credit ratings, analysts' opinions, state of the economy and yield curve characteristics), in this simplistic example the bonds would most like be issued at a discount to its par value to compensate for the lower coupon payments. The company will ultimately get less money for its bond than the stated par value, and the bonds are said to sell at a discount.
Example of bonds issued at a premium:
Company ABC issues a bond that will pay 10% a year for five years and similar bonds are currently paying 9%. The only way the company will sell this bond to investors is if the company sells the bond at a premium to its par value (for more money) to compensate the company for the paying a higher coupon. The company will ultimately get more money for its bond than the stated par value, and the bond is said to sell at a premium.
From an accounting standpoint, a company that sells a bond at a discount (or premium) will record on a cash basis a smaller interest payment but in reality will have a higher interest expense because it received fewer dollars for its bond. In accordance with the matching principle, premium and discounts must be amortized over the life of the bond. U.S. GAAP allows companies to amortize premiums or discounts by using a straight-line amortization or the effective interest rate method.
Discount vs. Premium Pricing
If coupon = market rate, the bond is issued at par.
If coupon > market rate, the bond is issued at a premium. The issuing company will get more money at initiation than it will pay to investors at maturity. In exchange it will pay a higher coupon than it would have to if the bond was issued at par.
If coupon < market rate, the bond is issued at a discount. The issuing company will get less money at initiation than it will pay to investors at maturity. In exchange it will pay a lower coupon than it would have to if the bond was issued at par.
Effects of Debt Issuance
Issuing debt impacts a company's financial statements differently depending on if the bonds are issued at par, at a premium or at a discount.
Bonds Issued at Par - Effects On:
- Income statement - The income statement will include an interest expense equal to the bond's coupon payment attributable to the specified accounting period.
- Balance sheet - The balance sheet will include at all times a long-term liability equal to the face value of the bond until its maturity or redemption.
- Cash flow statement - Going forward, cash flow from operations will include the interest expense recorded on the income statement. As of the issuing date, the company will account in cash flow from financing the total amount received for the bond.
Bonds Issued at a Premium - Effect On:
- Income statement - The income statement will include an interest expense equal to the bond's coupon payment minus the amortized portion of the premium received during the specified accounting period.
- Balance sheet - The balance sheet will include at all times a long-term liability equal to its carrying value. At initiation the carrying value will be equal to the face value of the bond plus the total unamortized premium. Every year the bond value recorded on the balance sheet will be reduced until the bond comes to maturity or is redeemed, and the bond value displayed on the balance eventually reaches the bond's original face value.
- Cash flow statement - Going forward, cash flow from operations (CFO) will include the actual coupon paid to the debt holder during the specified accounting period. Since this is a bond that was sold at a premium, it is paying out a larger coupon than is currently stated as an interest expense on the income statement. As a result, CFO will be understated relative to that of a company that sold its bond at par. The amortized portion of the bond premium will be included in cash flow from financing. This will cause the reported cash flow from financing to be overstated relative to that of a company that sold its bond at par.
Bonds Issued at a Discount - Effect On:
- Income statement - The income statement will include an interest expense equal to the bond's coupon payment plus the amortized portion of the discount received during the specified accounting period.
- Balance sheet - The balance sheet will include at all times a long-term liability equal to its carrying value. At initiation the carrying value will be equal to the face value of the bond minus the total unamortized discount. Every year the bond value recorded on the balance sheet will be increased until the bond comes to maturity and the bond value displayed on the balance is equal to the bond's face value.
- Cash flow statement - Going forward, cash flow from operations will include the actual coupon paid to the debt holder during the specified accounting period. Since this is a bond that was sold at a discount, it is paying out a smaller coupon than is currently stated as an interest expense on the income statement. As a result CFO will be overstated relative to that of a company that sold its bond at par. The amortized portion of the bond discount will be included in cash flow from financing. This will cause the reported cash flow from financing to be understated relative to that of a company that sold its bond at par.
Company ABC issues a $1M bond that will pay a 10% semiannual (coupon) for three years; the company will generate $500,000 EBITDA over the next three years. Contract the effect if market rate at the time of issuance was 10%, 11% and 9%. (Straight-line depreciation is used for premiums and discounts). Taxes are not considered.
Opening Balance Sheet
Investors: Ask Why the Company Issued New Debt
When a company issues new long-term debt, it's important for investors to understand the reason. Companies should give explanations of new debt's specific purpose rather than vague boilerplate such as "it will be used to fund general business needs." The most common purposes of new debt include the following:
- To Fund Growth - The cash raised by the debt issuance is used for specific investment(s). This is normally a good sign.
- To Refinance "Old" Debt - Old debt is retired and new debt is issued, presumably at a lower interest rate. This is also a good sign, but it often changes the company's interest rate exposure.
- To Change the Capital Structure - Cash raised by the debt issuance is used to repurchase stock, issue a dividend or buyout a big equity investor. Depending on the specifics, this may be a positive indicator.
- To Fund Operating Needs - Debt is issued to pay operating expenses because operating cash flow is negative. Depending on certain factors, this motive may be a red flag. Below, we look at how you can determine whether a company is issuing new debt to fund operating needs.
Be Careful of Debt that Funds Operating Needs
Unless the company is in the early growth stage, new debt that funds investment is preferable to debt that funds operating needs. To understand this thoroughly, recall from the cash flow installment that changes in operating accounts (that is, current assets and current liabilities) either provide or consume cash. Increases in current assets - except for cash - are "uses of cash." Increases in current liabilities are "sources of cash." Consider an abridged version of Real Networks' balance sheet for the year ending Dec 31, 2003:
From Dec. 2002 to Dec. 2003, accounts receivable (a current asset) increased dramatically and accounts payable (a current liability) decreased. Both occurrences are uses of cash. In other words, Real Networks consumed working capital in 2003. At the same time, the company issued a $100 million convertible bond. The company's consumption of operating cash and its issue of new debt to fund that need is not a good sign. Using debt to fund operating cash may be okay in the short run but because this is an action undertaken as a result of negative operating cash flow, it cannot be sustained forever.
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