Lyons Document Storage Corporation

Lyons Document Storage Corporation: Bond Accounting Roll No – G16105 Name – Saurabh Dwivedi XLRI, Jamshedpur

EXECUTIVE SUMMARY 

   

Lyons is exploring the possible consequences of repurchasing company bonds outstanding using cash obtained by issuing new bonds with lower interest rate and how this will affect annual interest payments, reported earnings and company’s financial position on the balance sheet. Management has decided to fund the company’s growth by issuing debt rather than by issuing additional equity. In 1999, bonds worth $10 million, 20 year maturity period and offering a coupon rate of 8% with interest paid semi-annually were issued. Only $9.1 million was received when the bonds were issued in 1999 (Carrying Value 9079920.779, Discount to be Amortized - 920079.221). In 1999 market interest rate was around 9% and at present (2009) it is 6%.

PROBLEMS IDENTIFIED & BEST POSSIBLE SOLUTION

1. Lyons Document Storage’s controller, Eric Petro, told Rene that the bonds were issued in 1999 at a discount and that only approximately $9.1 million was received in cash. Explain what is meant by the terms “premium” or “discount” as they relate to bonds. Compute exactly how much the company received from its 8% bonds if the rate prevailing at the time of the original issue was 9% as indicated in Exhibit 2. Also recompute the amounts shown in the balance sheet as December 21, 2006 and December 31, 2007, for Long-Term Debt. What is the current market value of the bonds outstanding at the current effective interest rate of 6%? Premium – If the bond value at the time of issuance by the borrower is more than face value of the bond then such bonds are called Premium bonds. If the coupon rate stated by the borrower (for example 9%) is more than prevailing market interest rate (for example 7%) then such bonds will be premium bonds. Discount – If the bond value at the time of issuance by the borrower is less than face of the bond then such bonds are called Discount bonds. If the coupon rate stated by the borrower (for example 6%) is less than prevailing market interest rate (for example 8%) then such bonds will be discount bonds.  Bonds issued in 1999 worth – 10000000  Number of Years to Maturity – 20  Coupon Rate – 8% (annually), 4% (semi-annually)  Periods = 20 * 2 = 40 (Since interest is paid semi-annually)  Market Interest Rate – 9% (annually), 4.5% (semi-annually)

Lyons Document Storage Corporation: Bond Accounting  Present Value of the Principal (At the time of issuance) – 10000000 / (1+.045) ^40 = 1719287.01  Present Value of the Interest – ((10000000 * .08)/2 *(1-(1/ (1+0.045) ^40)))/0.045 = 7360633.768 Therefore, total proceeds at the time of issuance –  P.V. of Principal + P.V of Interest = 9079920.779 (Company Received this amount in July 1999)  Total Discount Amortized = Bond Value – Proceeds = 10000000 - 9079920.779 = 920079.221

Date

Cash Paid

Interest Expense

Discount Amortized

Carrying Value of the Bonds

02-07-1999

********

***************

******************

9079920.779

02-01-2000

400000

408596.4351

8596.435054

9088517.214

02-07-2000

400000

408983.2746

8983.274632

9097500.489

02-01-2001

400000

409387.522

9387.52199

9106888.011

02-07-2001

400000

409809.9605

9809.96048

9116697.971

02-01-2002

400000

410251.4087

10251.4087

9126949.38

02-07-2002

400000

410712.7221

10712.72209

9137662.102

02-01-2003

400000

411194.7946

11194.79459

9148856.897

02-07-2003

400000

411698.5603

11698.56034

9160555.457

02-01-2004

400000

412224.9956

12224.99556

9172780.452

02-07-2004

400000

412775.1204

12775.12036

9185555.573

02-01-2005

400000

413350.0008

13350.00078

9198905.574

02-07-2005

400000

413950.7508

13950.75081

9212856.324

02-01-2006

400000

414578.5346

14578.5346

9227434.859

02-07-2006

400000

415234.5687

15234.56865

9242669.428

02-01-2007

400000

415920.1242

15920.12424

9258589.552

02-07-2007

400000

416636.5298

16636.52983

9275226.082

02-01-2008

400000

417385.1737

17385.17368

9292611.255

02-07-2008

400000

418167.5065

18167.50649

9310778.762

02-01-2009

400000

418985.0443

18985.04428

9329763.806

02-07-2009

400000

419839.3713

19839.37128

9349603.177

02-01-2010

400000

420732.143

20732.14298

9370335.32

02-07-2010

400000

421665.0894

21665.08942

9392000.41

02-01-2011

400000

422640.0184

22640.01844

9414640.428

02-07-2011

400000

423658.8193

23658.81927

9438299.248

02-01-2012

400000

424723.4661

24723.46614

9463022.714

02-07-2012

400000

425836.0221

25836.02212

9488858.736

02-01-2013

400000

426998.6431

26998.64311

9515857.379

02-07-2013

400000

428213.5821

28213.58205

9544070.961

Lyons Document Storage Corporation: Bond Accounting 02-01-2014

400000

429483.1932

29483.19324

9573554.154

02-07-2014

400000

430809.9369

30809.93694

9604364.091

02-01-2015

400000

432196.3841

32196.3841

9636560.475

02-07-2015

400000

433645.2214

33645.22139

9670205.697

02-01-2016

400000

435159.2563

35159.25635

9705364.953

02-07-2016

400000

436741.4229

36741.42288

9742106.376

02-01-2017

400000

438394.7869

38394.78691

9780501.163

02-07-2017

400000

440122.5523

40122.55233

9820623.715

02-01-2018

400000

441928.0672

41928.06718

9862551.782

02-07-2018

400000

443814.8302

43814.8302

9906366.612

02-01-2019

400000

445786.4976

45786.49756

9952153.11

02-07-2019

400000

447846.89

47846.88995

10000000

Total

920079.221

Re-computing the amount shown in balance sheet in Exhibit 2. Date

Discount Amortized (till 2006)

Date

Discount Amortized (till 2007)

02-01-2000

8596.435054

02-01-2000

8596.435054

02-07-2000

8983.274632

02-07-2000

8983.274632

02-01-2001

9387.52199

02-01-2001

9387.52199

02-07-2001

9809.96048

02-07-2001

9809.96048

02-01-2002

10251.4087

02-01-2002

10251.4087

02-07-2002

10712.72209

02-07-2002

10712.72209

02-01-2003

11194.79459

02-01-2003

11194.79459

02-07-2003

11698.56034

02-07-2003

11698.56034

02-01-2004

12224.99556

02-01-2004

12224.99556

02-07-2004

12775.12036

02-07-2004

12775.12036

02-01-2005

13350.00078

02-01-2005

13350.00078

02-07-2005

13950.75081

02-07-2005

13950.75081

02-01-2006

14578.5346

02-01-2006

14578.5346

02-07-2006

15234.56865

02-07-2006

15234.56865

02-01-2007

15920.12424

02-07-2007

16636.52983

Total

162748.6486

195305.3027

2006

2007

Discount Amortized for entire period

920079.221

920079.221

Total Amortized discount till 2006, 2007

162748.6486

195305.3027

Unamortized Discount

757330.5724

724773.9183

Bonds Payable

10000000

10000000

Carrying Value of bonds Payable

9242669.428

9275226.082

To calculate market value of bonds as of 02-Jan-2009 –

Lyons Document Storage Corporation: Bond Accounting  Number of periods = 20  Effective Interest Rate = 6% Annually, 3% Semi-Annually  Annuity Amount = 400000 From Present Value Ordinary Annuity of 1 table 4 below  PVA = 400000 * 14.877 = 5950800

Table – 4

From Present Value of 1 table 2 given below  Present value of face value = 1000000 * .55368 = 5536800

Table - 2 Therefore current market value of the bond  PV of Annuity + PV of FV = 5950800 + 5536800 = 11487600

2. If you were Rene Cook, would you recommend issuing $10 million, 6% bonds on January 2, 2009 and using the proceeds and other cash to refund the existing $10 million, 8% bonds? Will it cost more, in terms of principal and interest payments, to

Lyons Document Storage Corporation: Bond Accounting keep the existing bonds or to issue new ones at a lower rate? Be prepared to discuss the impact of a bond refunding on the following areas – a. Cash Flows b. Current year’s earnings c. Future year’s earnings Note: For purposes of your computations, assume that refunding, if selected, occurs effective January 2, 2009, at a price of $1154.15 per bond. Ignore the effects of income taxes. How many new $1000 bonds will Lyons have to issue to refund the old 9% bonds? For the period starting from Jan 2009, if new bonds are issued at 8% coupon rate then they will trade at premium since market rate mentioned in the case is 6%.  Market Interest Rate – 6% (Annual), 3% (Semi-annual)  Interest Paid – 8% (Annual), 4% (Semi-annual)  Number of Years – 11  Periods = 11 * 2 = 22 (Since calculated semi-annually)  Present Value of Principal = 10000000 * (1+.03) ^ 22 = 5218925.009  Present Value of Interest = ((10000000*.08/2)*(1-(1/(1+0.03)^22)))/0.03 = 6374766.655 Therefore, total proceeds at the time of issuance –  P.V. of Principal + P.V of Interest = 11593691.66  Premium = 11593691.66 – 10000000 = 1593691.664 Premium will be amortized as shown in table below – Cash Paid

Interest Expense

Premium Amortized

Carrying Value of the Bonds

*********

*************

***************

11593691.66

02-Jan-09

400000

347810.75

52189.25

11541502.41

02-Jul-09

400000

346245.07

53754.93

11487747.49

02-Jan-10

400000

344632.42

55367.58

11432379.91

Date

02-Jul-10

400000

342971.40

57028.60

11375351.31

02-Jan-11

400000

341260.54

58739.46

11316611.85

02-Jul-11

400000

339498.36

60501.64

11256110.2

02-Jan-12

400000

337683.31

62316.69

11193793.51

02-Jul-12

400000

335813.81

64186.19

11129607.31

02-Jan-13

400000

333888.22

66111.78

11063495.53

02-Jul-13

400000

331904.87

68095.13

10995400.4

02-Jan-14

400000

329862.01

70137.99

10925262.41

02-Jul-14

400000

327757.87

72242.13

10853020.28

02-Jan-15

400000

325590.61

74409.39

10778610.89

02-Jul-15

400000

323358.33

76641.67

10701969.22

02-Jan-16

400000

321059.08

78940.92

10623028.3

02-Jul-16

400000

318690.85

81309.15

10541719.14

02-Jan-17

400000

316251.57

83748.43

10457970.72

02-Jul-17

400000

313739.12

86260.88

10371709.84

Lyons Document Storage Corporation: Bond Accounting 02-Jan-18

400000

311151.30

88848.70

10282861.14

02-Jul-18

400000

308485.83

91514.17

10191346.97

02-Jan-19

400000

305740.41

94259.59

10097087.38

02-Jul-19

400000

302912.62

97087.38

10000000

Total

1593691.66

In terms of interest payments, it will be costlier to continue with existing bonds for another 11 years. Interest expense for new proposed bonds will be lower (assuming the coupon rate remains 8%) Below table shows the comparison of Interest Expense, Discount and Premium Amortization and carrying value of the bonds for the cases when Rene opts to continue with the existing bonds trading at discount or issue new bonds and refund existing bonds.

At Premium (Coupon - 8%, Market - 6%) - Proposed Interest Expense (lower than 400000)

Premium Amortized

Carrying Value of the Bonds

*************

***************

11593691.66

02-Jan-09

347810.75

52189.25

Date

At Discount (Coupon - 8%, Market - 9%) - Existing Interest Expense (higher than 400000)

Discount Amortized

Carrying Value of the Bonds

11541502.41

418985.04

18985.04

9329763.81

02-Jul-09

346245.07

53754.93

11487747.49

419839.37

19839.37

9349603.18

02-Jan-10

344632.42

55367.58

11432379.91

420732.14

20732.14

9370335.32

02-Jul-10

342971.40

57028.60

11375351.31

421665.09

21665.09

9392000.41

02-Jan-11

341260.54

58739.46

11316611.85

422640.02

22640.02

9414640.43

02-Jul-11

339498.36

60501.64

11256110.2

423658.82

23658.82

9438299.25

02-Jan-12

337683.31

62316.69

11193793.51

424723.47

24723.47

9463022.71

02-Jul-12

335813.81

64186.19

11129607.31

425836.02

25836.02

9488858.74

02-Jan-13

333888.22

66111.78

11063495.53

426998.64

26998.64

9515857.38

02-Jul-13

331904.87

68095.13

10995400.4

428213.58

28213.58

9544070.96

02-Jan-14

329862.01

70137.99

10925262.41

429483.19

29483.19

9573554.15

02-Jul-14

327757.87

72242.13

10853020.28

430809.94

30809.94

9604364.09

02-Jan-15

325590.61

74409.39

10778610.89

432196.38

32196.38

9636560.48

02-Jul-15

323358.33

76641.67

10701969.22

433645.22

33645.22

9670205.70

02-Jan-16

321059.08

78940.92

10623028.3

435159.26

35159.26

9705364.95

02-Jul-16

318690.85

81309.15

10541719.14

436741.42

36741.42

9742106.38

02-Jan-17

316251.57

83748.43

10457970.72

438394.79

38394.79

9780501.16

02-Jul-17

313739.12

86260.88

10371709.84

440122.55

40122.55

9820623.72

02-Jan-18

311151.30

88848.70

10282861.14

441928.07

41928.07

9862551.78

02-Jul-18

308485.83

91514.17

10191346.97

443814.83

43814.83

9906366.61

02-Jan-19

305740.41

94259.59

10097087.38

445786.50

45786.50

9952153.11

02-Jul-19

302912.62

97087.38

10000000

447846.89

47846.89

10000000.00

Total

1593691.66

If the bonds are refunded at 1154.15 then  Call Premium = 11541500 – 10000000 = 1541500

689221.24

Lyons Document Storage Corporation: Bond Accounting As per my understanding, since call premium of old bonds (1541500) is less than amortized premium of new bonds (1593691.66), Rene should go ahead with refund of old discount bonds and issuance of new premium bonds. How many new $1000 bonds will Lyons have to issue to refund the old 9% bonds? To refund old 9% bonds, amount required 11541500 (current price is $1154.15 in Jan 2009). Given the current market rate of 6%, a bond with a face value of $1,000.00 and paying a coupon rate of 8% (compounding Semi-Annually), should be selling for $1,159.37 (selling at a premium). Therefore number of new bonds = 11541500/1159.37 = 9955 Income statement Premium - 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. Discount - 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 Premium - 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. Discount - 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 Premium 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 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. Discount 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

Lyons Document Storage Corporation: Bond Accounting 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 3. Assume 6% bonds could be issued and the proceeds used to refund the existing bonds. Compare the effects of these transactions with those calculated in Question 2. If you were Rene Cook, what amount of new bonds would you recommend and why? If bonds are issued at 6% then they will trade at par since market interest rate is also 6%. In this case, present value of principal and interest will be as mentioned below. Present Value of Principal

5218925.01

Present Value of Interest

4781074.99

Proceeds

10000000.00

Since amount required to refund existing bonds (11541500) is higher than amount received from proceeds, Rene will have to issue more number of $1000 bonds i.e. 11542