In December 2008, Rene Cook sat in her cubicle trying to remember what she had learned in
Question:
In December 2008, Rene Cook sat in her cubicle trying to remember what she had learned in business school about bonds and bond accounting. Ms. Cook, a new MBA and special assistant in a training assignment with the company president, had just met with David Lyons, president of Lyons Document Storage Corporation. He had asked her to think about the possible consequences of repurchasing company bonds outstanding using cash that he felt could be obtained by issuing new bonds with a lower interest rate. My Lyons had asked Rene to focus on how much the company’s annual interest payments could be reduced, how reported earnings would be affected, and how the refunding would change the company’s financial position as referenced on the balance sheet, if at all.
The Company: The Lyons Company was a family business in the stationary supply business until the document storage opportunity appeared in the early 1990s. Lyons Document Storage Corporation was incorporated in 1993 to compete in the emerging and rapidly growing industry that provides secure, off-site storage of documents for other corporate customers. The demand for storage was fueled by the need for corporations to retain records of sales contracts, employment records, compliance records, and other documents. The convenience of secure storage and easy recovery in professionally managed warehouses appealed to corporate clients that wanted to save space in their more expensive office buildings. At the same time, the stationary supply business was growing more competitive with the entrance of Staples, Office Depot, and Office Max.
The 1990s were difficult for Lyons because there were still differences among management about directions and the company’s future. A large competitor, Iron Mountain, was expanding rapidly in the United States and internationally. When the decision to focus on document storage was made, it was imperative to move quickly to secure storage space and transportation equipment. Management decided to fund the company’s growth by issuing debt rather than by issuing additional equity. Lyons had operated conservatives without any long-term debt until it issued bonds in 1999. The bonds issued were $10 million in 20-year bonds, offering a coupon rate of 8%, with interest paid semiannually, and sold to yield the 9% market rate of interest at the time.
Current Situation: David Lyons had told Rene Cook that he felt the time might be ripe to refund the 1999 bond issue and replace it with bonds bearing lower interest rates. He had talked with the company’s investment bankers who had told him that $10 million in new 6% bonds with semiannual interest payments could be issued to provide the company with exactly $10 million, not considering underwriting costs and legal fees that were expected to be nominal. The bonds would pay $300,000 of interest every January 2 and July 2 with a payment of $10 million in principal at the end of 10 years. The new interest payments would be $200,000 less each year than those due on the old bonds, which still had 10 years before they would be paid off. To Lyons, that seemed to offer a saving over the old bonds.
The existing bonds had been issued on July 2, 1999 and would be due July 2, 2019. Interest was paid semiannually to holders of the bonds. Beginning her research, Rene reached for her copy of Lyons Document Storage’s 2007 Annual Report. (See Exhibit 1 for the Liabilities section of the 2007 Annual Report.) She was confused as to why the liability for the $10 million bonds was only $9.3 million at the end of 2007. To clarify her understanding, Rene called the company’s controller, Eric Petro, and learned that the 2005 bonds had been issued at a discount. Only about $9.1 million was received when the bonds were issued. For further information, Petro referred Rene to footnote 8 of the company’s 2008 financial statements (Exhibit 2).
Next, Rene went to the Internet to determine the market price of the company’s bonds. The current price was shown as 115.42 – reflecting the 6% yield the market for bonds was currently supporting. This meant that each $1,000 bond would have to be repurchased for $1,154. The company would have to spend $11.54 million to retire bonds that would be listed on the balance sheet at less than $9.3 million. The $2.24 million loss would shrink the 2009 projected earnings and slow the growth rate in earnings about which David Lyons was so proud. Rene knew this would not make Mr. Lyons happy. However, the lower interest payments associated with the new bonds would help reduce cash outflows in future years. Since it was getting late and the office was deserted, Rene cleared her desk and left the office for the week. During her bus ride home Rene wondered about her assignment. That evening she found and read again some notes that were among materials she had saved after business school (see exhibit 3). She had the weekend to think about her assignment. The recommendation she would make would have to be supported with a clear, straightforward analysis of the situation that carefully weighted each of the variables that concerned David Lyons.
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?
- I mainly don't understand how to calculate the long term debt on the balance sheet for the $10million bond and need help calculating the PV of the final settlement for the $11.54million bond as well as the coupon payments.
Exhibit 1: Liabilities and Shareholders’ Equity – December 31 ($ in thousands)
Current Liabilities: 2007 2006
Accounts Payable $8,756 $8,598
Accrued expenses including interest 1,751 1,756
Income taxes payable 2,488 2,350
Total current liabilities 12,995 12,704
Long term debit (Note 8) 9,292 9,259
Total Liabilities $22,287 $21,963
Shareholders' Equity:
Common Shares, $1 Par Value $2,838 $2,838
(5,000,000 authorized, 2,837,593 issued)
Additional Paid-In Capital $75,837 $75,837
Retained Earnings $151,279 $146,530
Total Shareholders' Equity $229,954 $225,205
Total Liabilities and Shareholders' Equity $252,241 $247,168
Exhibit 2 Long-Term Debt Footnote
On July 2, 1999, the company issued $10 million, 8% bonds payable that matured on July 2, 2019. Interest is payable semiannually on January 2 and July 2 of each year. The market rate of interest for similar bond offerings at the time our bonds were issued was 9%. For financial reporting purposes, the discount on bonds payable is amortized using the effective interest method over the life of the bonds. These bonds are presented in the accompanying balance sheet net of bonds discount as follows:
2007 2006
Bonds Payable $10,000 $10,000
Less: Unamortized Discount 708 741
Carrying Value of Bonds Payable $9,292 $9,259
Accounting for Governmental and Nonprofit Entities
ISBN: 978-0078025822
17th edition
Authors: Jacqueline Reck, Suzanne Lowensohn, Earl Wilson