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406 Financial Accounting: A Business Perspective 9e CHAPTER 15 LONG-TERM FINANCING: BONDS ANSWERS TO QUESTIONS 1. The major advantages of borrowing rather than issuing additional shares of stock are: a. Expansion is accomplished without surrendering ownership control (assuming interest and principal payments can be met when due) and a right to share in the net income of the corporation. b. Net income of the stockholders might be enhanced considerably by putting borrowed funds to work earning a rate of return higher than the cost of the borrowed money. c. Interest payments are a tax-deductible expense, while dividend payments are not. The major disadvantages are: a. The risk of becoming insolvent in case of a major loss is increased. b. There might be a reduction in flexibility of approach to problems through restrictive covenants in bond indentures, such as restrictions on stock acquisitions, dividends, and further borrowing. c. The earnings may fall so much that the assets secured through borrowing are earning less than their fixed cost, which reduces the net income of the corporation—literally the earnings of the stockholders—disproportionately. 2. A bond indenture is basically a contract between the issuing corporation and the bondholders, or a trustee representing them. The indenture contains a detailed statement of the rights, duties, and obligations of the issuer and the bondholders, such as contract rate of interest, maturity date, call provision, property pledged as security, dividend restrictions, etc. The contract typically involves the issuer and a trustee, typically a bank, representing the bondholders. Because the terms of the bonds to be issued must be set before they can be offered to the public, the contract cannot be between the issuer and the actual bondholders. A trustee is appointed to represent the bondholders and is thus the other contracting party. 3. The term coupon means that interest is paid when the appropriate interest coupon is detached from the bond and presented for payment. The term callable means that the bond can be redeemed at the issuer's option prior to maturity date. The term convertible means that the bond can be exchanged for shares of the issuer's common (usually) stock. A debenture is an unsecured bond. Therefore, a convertible debenture is an unsecured bond that may later be exchanged for common stock. 4. “Trading on the equity” (also called using financial leverage) is the act of using the existing stockholders' equity as a basis for borrowing funds with the expectation that the net cost of the funds will be less than the amount which can be earned with the funds. The borrowing is undertaken to increase the earnings per share of common stock. 5.
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This note was uploaded on 02/08/2011 for the course ACCT 2101 taught by Professor Turner during the Spring '08 term at Georgia Institute of Technology.

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