: Discuss the effect on reported cash flows of issuing zero-coupon debt.
·         Cash flows from financing and operations are affected by the particular bond issued.
·         Zero-coupon bonds have no deduction from cash flow from operations even though it has interest expense. All of its cash flows are included in financing activities.
·         Any bond issued at a discount will have more cash flow from operations (CFO is overstated) and less cash flow from financing (CFF is understated).
·         A bond issued at a premium will have more cash flow from financing (CFF is overstated) and less cash flow from operations (CFO is understated).
·         Times interest earned ratio is unaffected (holding the proceeds from the issue constant) although times interest earned on a cash basis is affected.
c: Compute and describe the effects of the issuance and the conversion of convertible bonds, warrants, and convertible preferred stock on financial statements and ratios.
Example: Given the following financial position:
Assets: $100,000
Liabilities: $ 50,000
Stockholders’ Equity: $ 50,000
So debt/equity = 1. If $50,000 of convertible debt is issued, then liabilities will be $100,000 and the debt-equity ratio will increase to 2.0. Interest expense will reduce net income. If $50,000 is received from the issue of debt with stock warrants and the warrants are valued at $10,000 ($40,000 associated with the debt), then liabilities will be $90,000 and equity will be $60,000. The debt-equity ratio will increase 1.5 (90,000/60,000). If $50,000 of non-redeemable preferred stock is issued, then stockholders’ equity will be $100,000 and the debt-equity ratio will decrease to 0.50. If $50,000 of redeemable preferred stock is issued, then stockholders’ equity will be $100,000. But for purposes of analysis, the redeemable preferred stock is treated as if it were debt (its current and arrears dividends as interest). Hence, total liabilities will be $100,000 and the debt-equity ratio increases to 2.0 .
d: Discuss the effect of changing interest rates on the market value of debt and on financial statement ratios.
Changes in market interest rates lead to changes in the market v