Tag Payment

Cost of long term debt

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The first long term source of finance that we consider is the cost of long term debt, which is usually the cheapest of the long-term sources of finance. The majority of long term debt of large corporations is the result of issuing bonds.

Flotation cost

Companies that issue bonds have to take into account the flotation cost, which is the complete cost the company has to incur to issue and sell a security, such as common stock, preferred stock and bonds. This cost reduces the company’s net proceeds from issuing security.

Flotation cost consists of underwriting and administrative costs. Underwriting costs are payment to investment bankers for their services and administrative costs are costs other than the underwriting costs of issuing bonds.

Finding the before-tax cost of long-term debt (rd)

To find the after-tax cost of long term debt, we first need to find the before-tax cost of long term debt (rd). As mentioned above, the majority of long term debts of large corporations are the result of issuing bonds. By using a financial calculator, we can find the before tax cost of a bond (cost of long-term debt).

THE CALCULATION FOLLOWS:

FV – (future value of the bond which refers to its par value, which is also called the face value, and is usually $1,000)

PV – the value of the bond today at which it is sold (after deducting the flotation cost)

PMT – payment on the bond (for example, at 8% coupon interest rate a bond issuer will have to make annual payments of $80 if the par value is $1,000). Payments can also be made more frequently, such as semi-annually or even monthly, but in such a case we need to adjust the amount of payment and number of periods.

For example, if payment is made semi-annually, we will need to divide $80 by 2 and we will need to multiply number of periods by 2.

N – Number of periods

Calculate I – the cost of the bond (for the bond’s issuer it is the cost to maturity of the cash flows, for the bond’s holders it is the return they earn on buying and holding this bond to maturity). Within the context of our discussion, it is also the before-tax cost of long-term debt.

Note that if the net proceeds from the sale of the bond is the same as the face value of the bond than the before-tax cost of long-term debt will be equal to the coupon interest rate. For example, at 8% coupon interest rate, the par value of $1,000 and net proceeds of $1,000 (no flotation costs), the before-tax cost of long-term debt will equal 8%.

Finding the after-tax cost of long-term debt

After we found the before-tax cost of long term debt, we need to find the after-tax cost of long term debt. To do so all we need to do is to multiply the before-tax cost of long-term debt by (1-T), where T stands for the tax rate.

THEREFORE:

ri = rd * (1-T)

EXAMPLE:

If the before-tax cost of long term debt is 10% and tax rate is 28% then the calculation will be as follows:

Ri =10% * (1-.28)

Ri =10% * .72

Ri = 7.2%

Test yourself

You need to calculate the after-tax cost of a 30-year bond. The coupon interest rate is 10%, the par value is $1,000 and the bond is currently selling at $950.

SOLUTION:

PV: -950

FV: 1,000

PMT: 100

N: 30

I: 10.56%

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

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Fixed Payment Coverage Ratio

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The fixed payment coverage ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. In other words, the fixed payment coverage ratio measures the ability to service debts.

As outsiders, when analyzing the capital structure decisions of firms, we can use the fixed payment coverage ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk.

The formula for the fixed payment coverage ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT = earnings before interest and tax (operating profit)

LP = lease payments

I = interest charges

PP = principal payments

PSD = preferred stock dividends

T = tax rate

Test yourself

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The fixed payment coverage ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The fixed payment coverage ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, the ratio should be compared to the industry average before any conclusions are drawn.

Note the following

Generally, the higher the ratio the lower the risk that  enterprise will not be able to meet its fixed-payment obligations on time. Therefore, generally, a higher ratio is better. However, as with times interest earned ratio, cognizance needs to be taken of the fact that the higher the ratio the lower the risk and lower the return.

Therefore, at some point, the fixed payment coverage ratio may be too high. This will occur if a business is unnecessarily careful with taking up more debt. This will result in very low risk, but also in lower return. This, of course, is not aligned with the overall goal of the enterprise, which is the maximization of the wealth of its shareholders.

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Average Payment Period

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Average payment period (APP) is one of the activity ratios which measures the relationship between accounts payable and average purchases per day. Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average collection period, total asset turnover and inventory turnover analysis.

APP calculates how efficiently accounts payable are settled. It indicates, on average, how many days does it take to pay off accounts payable. APP is also referred to as the average age of accounts payable or the accounts payable turnover ratio.

The formula to calculate the APP is as follows:

APP = Accounts payable/Average purchases per day

The figure for accounts payable is obtained from the balance sheet and the figure for purchases is indirectly obtained from the income statement. Here the difficulty of calculating APP is highlighted. A figure for purchases is usually not available. Therefore, purchases are usually estimated as a percentage of cost of goods sold, which is in turn obtained from the income statement.

Purchases must be adjusted for credit purchases. This is done by deducting cash purchases. Further, credit purchases must be divided by the number of days per year to finally obtain average purchases per day.

Average credit purchases per day = Credit purchases/365

Example calculation

Assume First Parsons Company has accounts payable of $840,000 and credit purchases of $5,300,000. First Parsons Company was granted credit terms of 30 days by all its creditors. Assume there are 365 days year.

The average payment period of First Parsons Company is calculated as follows:

Firstly, we need to calculate the average credit purchases per day.

Average credit purchases per day = Credit purchases/365

= $5,300,000/365

= $14,520.55

Now, we are ready to calculate APP.

= $840,000/$14,520.55

=57.85 days

= 58 days

The APP of the First Parsons Company is 58 days. It takes on average 58 days to settle the accounts payable. However, the credit terms granted by creditors to First Parsons Company is 30 days. This means that company’s creditors require accounts to be settled within 30 days.

In light of this information, it is evident that payment of accounts payable is inadequately managed. If First Parsons Company will not attend to this issue in a timely manner, the current payment practices may lead to a number of harmful effects. Such harmful effects may include the inability to buy on credit from current suppliers, damage to the credibility of the business and a significantly deteriorating credit rating. This will be very harmful for the firm due to the further limitations it will impose on obtaining credit.

Things to note about this ratio

The average payment period analysis is only relevant when compared to credit terms granted to the business.

APP allows businesses to gain a better understanding of the cash outflows to be anticipated. Understanding of cash outflows is vital for successful operation of the business.

Average payment period analysis also identifies trends in the payment of the accounts payable. This can bring to management’s attention important variables that must be investigated to ensure successful operation of the business. For example, if the APP of the business increased from 30 to 68 days over 1 year while credit terms extended to the business remained the same at 30 days, a further investigation will be required to understand such a large increase in this ratio.

Further, to obtain a better understanding, one should compare the APP ratio to industry averages, to the ratio of leading firms in the industry and to the firm’s own historical results.

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