Joan Holtz (D)
Essay Preview: Joan Holtz (D)
Report this essay
Case 8-4: Joan Holtz (D)*
Note: This case is unchanged from the Tenth Edition.
Approach
As with the earlier Joan Holtz cases, this one enables students to discuss some interesting issues, none of which requires a full class period. The instructor should be alert to newer situations to augment or supplant any of those described in the case. Also many of these issues tend eventually to result in an FASB, AICPA, or SEC pronouncement. Since seldom will a beginning student be aware of these pronouncements, they do not preclude continuing to use a part of this case, and then revealing at the end of that parts discussion whether the accounting rule-making body reached the same conclusion as the class did.
Comments on Questions
The question is equivalent to asking, what is the future value of $100 invested at 10 percent compound interest, 127 years (1998 – 1871) from now? The answer is $100 (1,10)127 = $18,066,000. We subsequently read that the man, after giving his town officials a good scare, did not pursue the matter further, becausehad he prevailedit would have bankrupted the town.
For a future value of $1,000 received 8 years hence, and a 15 percent discount rate, the present value is $327; so, yes, the yield was 15 percent. (This result can be gotten using a calculator, or by noting in Appendix Table A that the 8 yr., 15% PV factor is 0.327.)
The discount is $1,000 – 327 = $673; using straight-line amortization, that is $673 divided by 8 = $84.125/bond/yr., resulting in annual tax savings of $84.125 * 0.40 = $33.65. (Subsequent to the writing of the case, the U.S. Treasury reduced, but did not eliminate, the tax deductibility of original issue discount, so these zero-coupon bonds became less attractive.) Thus, the bond issuer contemplates the following cash flow pattern:
Time Zero
+ $327
Years 1-8
+ $33.65/yr.
End of year 8
– $1,000
(Actually, straight-line discount amortization is not permitted, but we wanted to keep the calculations as simple as possible.) We need to make the sum of the PVs of the eight-year stream and negative future flow equal $327, i.e., find the rate that gives an NPV of zero. By trial and error, this rate can be found to be approximately 8.5 percent. (A calculator shows it to be 8.63 percent.)
With 15 percent bonds issued for par, the net-of-tax interest payment stream is simply $150 (1-0.40) = $90/bond/yr. for 8 years. If one makes a calculation like the one for part (b), but with Time Zero in flow equal to $1,000 (instead of $327) and the annual outflows equal to $90 (instead of $33.65 annual inflows), the rate giving an NPV of zero (remember the Year 8 $1,000 outflow, as well) is 9.0 percent. (Actually, trial-and-error or calculators arent needed here; once the $90/year amount is determined, the rate of 9.0 percent is also determined, since $90 divided by $1,000 = 9.0 percent. The student who quickly realizes this understands the meaning of a “true” return on investment of 9.0 percent.) Thus, from the standpoint of the bondholder, ignoring taxes, the yield on either bond is 15%, but the cost to the issuer of the zero-coupon bond is lower. Actually, zero-coupon bonds are generally purchased by tax-exempt institutions, so this comparison ignoring taxes is valid. However, for taxable bondholder entities, the zero-coupon bond discount amortization is taxable as ordinary interest income. In the early 1980s, zero-coupon bond mutual funds have sprung up for use by IRAs.
Although the text describes refunding a bond issue, it does not explicitly describe early extinguishment of debt. Actually, refunding a bond issue is just a special case of early extinguishment: the proceeds to retire the current debt come from a new debt issue. In the “debt-for-equity swap” were considering, the substance of the transaction is the same as if the company issued shares and then used the cash proceeds to buy its bonds on the open market; in effect, the company is simply paying an investment banker to do this on the companys behalf. (In practice, an investment banker would be used to market newly issued common stock, whatever the intended use of the proceeds.) But in fact, a company is motivated in the debt-for-equity swap to use the investment banker as an intermediary because the tax laws are such that if the company handled the transactions on its own, it would pay taxes on the difference between the repurchase cost of the bonds and their balance sheet carrying value, irrespective of the source of the funds used to repurchase the bonds. Of course, we do not expect students to be aware of this anomaly in the tax lawbut they might well surmise it, since, again, the substance is the same whether the transaction is handled by the company or by an investment banker.
As to whether the company has “really earned” its gain on the swap will be debated by the students. In the Exxon example given, ask for journal entries to reflect the transaction. These will be:
dr. Bonds Payable
72 million
cr. Capital Stock
43 million
cr. ?
29 million
To what account should the “hanging credit” of $29 million be made? If it were made to Capital Stock, the value of the consideration for the stock (i.e., bonds plus investment bankers fee worth a total of $43 million) would be overstated. Or if Bonds Payable is debited for only $43 million (which is equivalent to making the “hanging credit” to Bonds Payable), then the actual retirement of a $72 million obligation is not reflected. Thus, by process of elimination, the $29 million has to be credited to Retained Earnings. In fact, the same treatment cited in the text for bond refunding, coming from APB-26 and FASB-4, applies here, with the gain shown as an extraordinary item (described in Chapter 10) on the income statement, rather than bring a direct credit to Retained Earnings (i.e., rather than not being flowed through the income statement). The effect of this treatment is to “reward” the company (through higher reported earnings) for being savvy enough to retire its debt early when the debts market price was depressed.
Discussion of this technique should also bring out that the swap improves the companys debt/equity ratio and interest coverage (times interest earned). The price the company pays for this is possible dilution of earnings per share resulting from the additional shares outstanding. However, as the preceding journal entries