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The Essential Elements of Long-Term Debt, Research Paper Example

Pages: 7

Words: 1941

Research Paper

Abstract

The objective of this work is to define the essential elements of long-term debt and describe important characteristics of publicly issued long-term bonds. This work will also compare public forms of long-term financial with private placement debt/bonds. This work will also answer the question of what the advantages and disadvantages public forms of long-term financial and private placement debt/bonds. Long-term debt is described as bonds, loans and any type of debt with a maturity of longer than one year. Long-term debt is generally used for outlays of capital and is also referred to as funded debt. (Farlex Financial Dictionary, 2009)

Long-Term Finance Research Study

Objective

The objective of this work is to define the essential elements of long-term debt and describe important characteristics of publicly issued long-term bonds. This work will also compare public forms of long-term financial with private placement debt/bonds. This work will also answer the question of what the advantages and disadvantages public forms of long-term financial and private placement debt/bonds. Long-term debt is described as bonds, loans and any type of debt with a maturity of longer than one year. Long-term debt is generally used for outlays of capital and is also referred to as funded debt. (Farlex Financial Dictionary, 2009)

Introduction

The work of Needles and Powers (nd) states that long-term liabilities are “obligations of business that re due to be paid after one year or beyond the operating cycle, whichever is longer.”  Stated as well is that decisions that are related to long-term debt are critical in nature since the company’s financing of its operations is the factor of primary importance in the long-term viability of the company. (Needles and Power, nd, paraphrased)  As well, it is reported that the amount of debt and type of debt incurred by a company is dependent upon various factors, which include: (1) the nature of the business; (2) the businesses competitive environment; (3) the state of the financial markets and the predictability of its earnings. (Needles and Powers, nd, paraphrased)

Essential Elements of Long-Term Debt

Long-Term Debt bonds are stated to include: (1) Secured and unsecured bonds which are collateral backed bonds; (2) Term Serial and Callable Bonds which are bonds that mature or are paid out on one  date; (3) Convertible, commodity-backed and deep discount which can be exchanged for other securities of a corporation; (4) Registered with Coupon Bonds which are bonds with the owners name on them and are non-transferable; and (5) Income and Revenue bonds – income bonds pay no interest unless a company is making a profit. (Long-Term Debt: Bonds, nd) Reasons that a business may assume long-term debt include finance and investments in R&D activities and in long-term assets. (Needles and Powers, nd, paraphrased) Two primary sources of long-term funding are: (1) issuing of capital stock; and (2) issuing of long-term debts including such as bonds, notes, mortgage s and leases. (Needles and Powers, nd, paraphrased) Management issues relating to long-term debt include questions relating to whether or not to incur long-term debt, how much long-term debt to incur and what types of long-term debt to incur for the business

The work of Zimmerman (nd) states that prior to the 1960s there was no tax laws that prevented stated that local and state officials could not issue bonds and then use to proceeds for financing investments for private individuals and businesses. This was referred to as ‘conduit financing’, which “became an increasingly larger share of the total volume of bonds from the early 1970s through the early 1980s. “ (Zimmerman, nd ) It is stated that the majority of the legislation that related to tax-exempt bonds between 1968 to 1998 is representative of an effort to bring about a reduction in this “conduit financing”. (Zimmerman, nd) Legislation is stated to have placed restrictions on tax exemption to bonds issued for activities that satisfy some broadly defined ‘public’ purpose, that is, for which federal taxpayers are likely to receive substantial benefits” (Zimmerman, nd)

Important Characteristic of Publicly Issued Long-Term Bonds

Bonds that are used in business activities are held to “satisfy a public purpose if they meet either of two criteria as follows: (1) no more than 10 percent of the proceeds are used directly or indirectly in a trade or business; and (2) no more than 10 percent of the proceeds are secured directly or indirectly by property used in a trade or business. (Zimmerman, nd)

Long-term bonds have different characteristics including:

  • Time until repayment;
  • Amount of interest;
  • Ability to repay early; and
  • Conversion into other securities. (Needles and Powers, nd)

Long-term, debt types include such as:

  • Long-term notes;
  • Mortgages; and
  • Long-term leases. (Needles and Powers, nd)

Comparison of Long-Term Financial with Private Placement Debt/Bonds

Bonds are securities, which are generally long-term and representative of money borrowed from the investing public by a corporation or other entity. (Needles and Power, nd, paraphrased) Bonds are required for repayment at a specific time with specified periodic interest payments. Bondholders are stated to be creditors and the bond is a promise for repayment of the borrowed amount or the principal in addition to the interest, which are repaid on specific future dates, and specific rates of interest. (Needles and Powers, nd, paraphrased)

Bonds that satisfy either of the tests are stated to be “governmental bonds” which are issuable without limitations. Bonds that do not meet these tests are held to benefit primarily private businesses and are referred to as ‘private-activity’ bonds, which are not eligible for tax-exempt financing. Bonds that are for more than 5% of the proceeds are used for financing loans to individuals and are held to benefit individuals primarily and are referred to as ‘private-activity’ bonds and are not eligible for tax exemption.

Activities that do not meet the two business tests or the private loan test are held as proving some public as wellas some private benefits and are termed ‘qualified private activities’ and can be financed with tax exempt bonds. The greatest part of bonds that are issued for qualified private activities are such as those that finance mortgages for owner-occupied housing, student loans for postsecondary education, and loans for private manufacturing facilities. (Zimmerman, nd) Zimmerman reports that legislative changes had by 1990 “succeeded in reducing private activity bonds to 20 percent.” (nd)

In regards to private placements, the issuance of equity and debt securities sometimes takes place “directly between the issuer and the investor. This is a private placement in which generally, “a select group of investors is involved and most private placements are for the issuance of debt instruments not stock.” (Evans, nd ) Direct business loans with terms exceeding 15 years are also classified as private placements. These placements are not subject to the SEC formal registration process and are not as expensive to issue however, there are often restrictive covenants imposed by investors as there is a lack in market for such securities resulting in investors demanding a higher rate of return.

Regulations imposed on private placements include: (1) No advertising of the securities is allowed; (2) The issuing company must exercise care to ensure that investors are buying for their own accounts and not engaged in underwriting services; and (3) The SEC must be notified within 15 days of the first offering. (Evans, nd )

Advantages and Disadvantages of Public Forms of Long-Term Financial and Private Placement Debt/Bonds

Advantages of long-term debt include the following advantages:

  • Common stockholders do not relinquish control,
  • Interest on debt is tax deductible, and
  • financial leverage may increase a company’s (Needles and Powers, nd)

Disadvantages of long-term debt are stated to be the following:

  • interest and principal must be repaid on schedule, and
  • financial leverage can work against a company if a project is not successful. (Needles and Powers, nd)

Advantages of Common Stock over Debt

Advantages of common stock over debt include that:

  • it does not have to be repaid;
  • dividends are paid only if sufficient income is earned by the company. (Needles and Powers, nd)

Advantages of Long-Term Debt Over Common Stock

Advantages of long-term debt over common stock are stated to include the following:

  • stockholder control;
  • tax effects; and
  • financial leverage. (Needles and Powers, nd)

Debt financing has inherent disadvantages including those as follows:

  • Cash required to make periodic interest payments and to pay principal amount;
  • Company can become overcommitted;
  • Financial leverage can work against a company if the earnings from its investments do not exceed its interest payment; and
  • Managers must know the characteristics of the various types of long-term liabilities so that they can structure a company’s long-term financing to the best advantage of the company. (Needles and Powers, nd)

Needles and Powers state that a bond indenture is written for the purpose of fitting the businesses’ financial needs and that bonds may have several features including:

  • The bond is secured or unsecured;
  • The bond is term or serial; and
  • The bond is registered or coupon. (Needles and Powers, nd)

Unsecured bonds or debentures “are issued based on the company’s credit rating” while secured bonds are those providing bondholders with a pledge of certain assets which guarantee repayment of the bond. (Needles and Powers, nd)  Term bonds are of the nature that will all mature at the same time while serial bonds are those maturing on different dates. (Needles and Powers, nd) State supported debt is stated in the work of Weismann (nd) to be defined as “…bonds or notes, including bonds or notes issued to fund reserve funds and costs of issuance, issued by the state or a state public corporation for which the state is constitutionally obligated to pay debt service or is contractually obligated to pay debt service subject to appropriation, except where the state has a contingent contractual obligation.” (Weissman, nd) It is reported that there are two main methods that public authorities use in issuing State-supported debt: (1) a lease through a lease-purchase or lease-lease-back arrangement between a State agency and public authority; and (2) a form of a contract, sometimes called a service contract or financing agreement. Under this arrangement, there is no transfer or leasing of the improvement being financed and the improvement is not available as security for the bondholder. Rather, the state agency and the public authority execute an agreement whereby the State agency agrees to make payments to the public authority, subject to appropriation by the Legislature, to cover annual debt service and the other previously mentioned costs associated with the debt. The public authority makes the bond proceeds available for the improvement being undertaken.” (Weissman, nd)

Summary & Conclusion

The objective of this work is to define the essential elements of long-term debt and describe important characteristics of publicly issued long-term bonds. This work has as well compared public forms of long-term financing with private placement debt/bonds. Two primary sources of long-term funding are: (1) issuing of capital stock; and (2) issuing of long-term debts including such as bonds, notes, mortgage s and leases. (Needles and Powers, nd, paraphrased) This study has found that the advantages of long-term debt include: (1) Common  stockholders do not relinquish control, (2) Interest on debt is tax deductible, and  (3)  financial leverage may increase a company’s   earnings.(Needles and Powers, nd) Findings of this study include that the disadvantages of long-term debt include: (1) interest and principal must be repaid on  schedule, and (2) financial leverage can work  against a company if a project is not successful. (Needles and Powers, nd) Advantages of long-term debt over common stock include the factors of: (1) stockholder control; (2) tax effects; and (3) financial leverage. (Needles and Powers, nd)

References

Long-Term Debt (2009) Farlex Financial Dictionary. © 2009 Farlex, Inc. Retrieved from: http://financial-dictionary.thefreedictionary.com/long-term+debt

Long-Term Debt: Bonds (nd) Retrieved from: http://www.jpec.org/handouts/jpec90.pdf

Evans, M.H. (nd) The Management of Capital. Excellence in Financial Management. Retrieved from: www.exinfm.com/training.

Needles, B.E. and Powers, M. (nd) Long-Term Liabilities. Chapter 11.  Accounting. New Orleans University. Retrieved from: http://www.college.cengage.com/accounting/needles/fa/instr/ppt/ch11/sld001.htm

Weissman, G.H. (nd) The Reality v. Legality of Conduit Financing by the State-Public Authorities, the Chosen Financiers. Retrieved from: http://www.publicauthority.org/files/weissman.pdf

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