review10 - CHAPTER 10 Long-Term Liabilities 0REVIEWING THE...

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CHAPTER 10 Long-Term Liabilities 0REVIEWING THE CHAPTER Objective 1: Identify the management issues related to long-term debt. 10. To foster growth, companies often invest in long-term assets and in research and development and other activities that will benefit the business in the long run. To finance these investments, they must obtain long-term funding. They commonly do so by issuing stock and long-term debt in the form of bonds, notes, mortgages, and leases. Long-term debt consists of liabilities to be settled beyond one year or the normal operating cycle, whichever is longer. The management issues related to issuing long-term debt are whether to issue it, how much of it to carry, and what types of it to incur. 20. In considering whether to issue long-term debt, management must weigh the advantages of this method of obtaining funds against the advantages of relying solely on stockholders’ equity. 0 a0. One advantage of issuing long-term debt is that bondholders and other creditors do not have voting rights, and common stockholders therefore retain their level of control. Another advantage is that interest on debt is tax-deductible, which lowers the company’s tax burden. A third advantage of issuing long-term debt is that it may give the company financial leverage —that is, if earnings on the funds obtained exceed the interest incurred, then stockholders’ earnings will increase (this is also called trading on equity ). b0. One disadvantage of issuing long-term debt is that the more of it a company issues, the more periodic interest it must pay. Failure to pay either periodic interest or the principal at maturity can force a company into bankruptcy. Another disadvantage is that financial leverage can work against a company if the earnings from its investments do not exceed its interest payments. Thus, when a business issues long- term debt, it assumes financial risk, as well as the possibility of negative financial leverage. 30. Managers can determine how much debt to carry by computing the debt to equity ratio. It is expressed in “times” and is calculated as follows: Total Liabilities Total Stockholders’ Equity 40. When a business structures its long-term debts in such a way that they do not appear as liabilities on the balance sheet (as for certain leases), that business is engaging in off- balance-sheet financing. However, because the business is committed to cash payments in the long-run, off-balance-sheet financing has the same effect as long-term liabilities. The practice is perfectly legal. 50. Financial leverage is advantageous as long as a business is able to make timely interest payments and to settle the debt at maturity. A common measure of how much risk a
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company undertakes in issuing debt is the interest coverage ratio. It is expressed in “times” and is calculated as follows: Income Before Income Taxes + Interest Expense Interest Expense The higher the interest coverage ratio, the lower the company’s risk will be of defaulting on
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This note was uploaded on 06/10/2009 for the course ACG 2021 taught by Professor Magoulis,b during the Spring '08 term at Pasco-Hernando Community College.

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review10 - CHAPTER 10 Long-Term Liabilities 0REVIEWING THE...

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