Case Analysis:

National Document Storage Company: Bond Evaluation

In late December 2008, Larisa Crest sat in her cubicle trying to remember what she had learned in business school about bonds and bond accounting and financing. Ms. Crest, a new MBA and special assistant in a training assignment with the company president, had just met with David National, president of National Document Storage Company. He has asked her to think about the possible consequences of repurchasing company bonds outstanding using cash that he felt could be obtained by issuing new bonds with a lower interest rate. Mr. National had asked Larisa to focus on how much the company's bonds with a lower interest payments could be reduced, how reported earnings would be affected, and how the refunding would change the company's financial position as referenced on the balance sheet, if at all.

The Company

The National Company was a family business in the stationary supply business until the document storage opportunity appeared in the early 1990's. National Document Storage was incorporated in 1993 to compete in the emerging and rapidly growing industry that provides secure off-site storage of documents for customers. The demand for storage was driven by the need for corporations to retain records of contracts, employment records, compliance records, legal and other documents. The convenience of secure storage and easy recovery in professionally managed warehouses attracted clients that wanted to save space in their more expensive office buildings. At the same time, the stationary supply business was growing more competitive with the entrance of Staples, Office Depot and Office Max.

The 1990s were difficult for National because there were still differences among management about directions and the company's future. A large competitor, Iron Mountain, was expanding rapidly in the United States and internationally. When the decision to focus on document storage was made, it was imperative to move quickly to secure storage space and transportation equipment. Management decided to fund the company's growth by issuing debt rather than by issuing additional equity. National was a conservative company with no long-term debt until it issued bonds in 2000. The bonds issued were 10 million in 20-year bonds, offering a coupon rate of 8% with interest paid semiannually, and sold to yield the 9% market rate of interest at the time.

Current Situation

David National had told Larisa Crest that he felt the time might be ripe to refund the 2000 bond issue and replace it with bonds bearing lower interest rates. He had talked with the company's investment bankers who had told him that $10 million in new 6% bonds could be issued to provide the company with exactly $10 million, not considering underwriting costs and legal fees that were expected to be nominal. The bonds would pay $300,000 interest every January 2 and July 2 with a payment of $10 million in principal at the end of 10 years. The new interest payments would be $200,000 less each year than those due on the old bonds, which still had 12 years before they would be paid off. To National, that seemed to offer it saving over the old bonds.

Beginning her research, Larisa reached for her copy of National Document Storage's 2008 Annual Report. (See Exhibit 1 for the Liabilities and Shareholders' Equity section of the 2008 Annual Report.) She was confused as to why the liability for the $10 million bonds was only $9.3 million at the end of 2008.

To clarify her understanding, Larisa called the company's controller. Eric Geiger, and learned that the 2000 bonds had been issued at a discount. Only about $9.1 million was received when the bonds were issued. For further information, Petro referred Larisa to footnote 8 of the company's 2008 financial statements (Exhibit 2).

Next Larisa went to the internet to determine the market price of the company's bonds. The current price was shown as $115.43 - reflecting the 6% yield to maturity (market yield) for the bonds was currently supporting. This meant that each $1,000 bond would have to be repurchased for about $1,160. The company would have to spend $11.60 million to retire bonds that were listed on the balance sheet at $9.3 million. The $2.25 million loss would shrink the 2009 projected earnings and slow the growth rate in earnings about which David National was so proud. Larisa knew this would not make him happy. However, the lower interest payments associated with the new bonds would help reduce cash outflows in future years.

Since it was getting late and the office was deserted, Larisa cleared her desk and left the office for the week. During her bus ride home, Larisa wondered about her assignment. That evening she found and read again some note that were among materials she had saved after business school (see Exhibit 3). She had the weekend to think about her assignment. The recommendation she would make would have to be supported with a clear, straightforward analysis of the situation that carefully weight each of the variables that concerned David National.

Student Assignment

1.National Document Storage's controller, Eric Geiger, told Larisa that the bonds were issued in 2000 at a discount and that only approximately $9.1 million was received in cash. Explain what is meant by the terms "premium" or "discount" as they relate to bonds in this case. Compute exactly how much the company received from its 8% bonds if the rate prevailing at the time of the original issue was 9% as indicated in Exhibit 2. Also, re-compute the amounts shown in the balance sheet at December 31, 2007, and December 31, 2008, for Long-Term Debt. What is the current market value of the bonds outstanding at the current-effect interest rate of 6%?

2.If you were Larisa Crest, would you recommend issuing $10 million, 6% bonds and using the proceeds and other cash to refund the existing bonds or to issue new ones at a lower rate? Be prepared to discuss the impact of a bond refunding on the following areas:

Cash flows

Current year's earnings

Future years' earnings

Balance sheet presentation

Note: For purposes of your computations, assume that refunding, if selected, occurs effective January 2, 2009, at a price of $1,115.43 per bond. Ignore the effects of income taxes. How many new $1,000 bonds will National have to issue to refund the old 9% bonds?

3.Assume 6% bonds could be issued and the proceeds used to refund the existing bonds. Compare the effects of these transactions with those calculated in Question two. If you were Larisa Crest, what amount of new bonds would you recommend and why?

Exhibit 1 Liabilities and Shareholders' Equity ---- December 31 ($ in thousands)

20082007

Current Liabilities

Accounts payable $ 9,237$ 8,756

Accrued Expenses1,8261,768

Income taxes payable2,5952,488

Total Current Liabilities13,658 13,012

Long term debt (Note 8)9,3119,275

Total Liabilities$22,969$ 22,287

Shareholders' Equity

Common shares, $1 par value ($5,000,000

Authorized, 837,595 issued) $2,838$2,836

Additional paid-in capital75,83775,837

Treasury Stock(537)- 0 -

Retained earnings 158,922 151,279

Total Shareholders' equity 237,060229,954

Total liabilities and shareholders' equity$ 260,029$ 252,241

Exhibit 2Long-Term Debt Footnote

On January 2, 2000, the company issued $10 million, 8% bonds payable on July 2, 2019. Interest is payable semiannually on January 2 and July 2. The market rate of interest at the time for companies like ours was 9.0%. For financial reporting purposes, the discount on bonds payable is being amortized using the effective interest method over the life of the bonds. These bonds are presented in the balance sheet net of bond discount as follows (in thousands of dollars):

20082007

Bonds payable$10,000$10,000

Less: Unamortized discount689725

Carrying value of bonds payable$9,311 $ 9,275

Exhibit 3 Some Notes about Bonds that Larisa Crest found in her business school files

The amounts that business firms and other organizations wish to borrow are sometimes quite large - larger than any single lender may be willing to or able to provide. For this reason, securities are created. One general category of borrowing instruments is that of bond indentures. The terms of a loan are specified in a master contract between the entity, which is the borrower, and the bondholders, who are the lenders. Each bondholder receives a certificate showing the total indebetness represented by the certificate and the terms of his or her contract with the firm.

All bond agreements have three basic features:

1.The term of the loan is specified

2.A face value of the loan is specified

3.The repayment schedule is shown either in detailed amounts or as a percentage rate of interest to be paid at intervals based upon the face amount of the bond.

Bonds are typically issued in multiples of $1,000, so let us assume than an organization is offering to sell a bond with a term of 10 years, a face amount of $1,000, and semi-annual payments based on an interest rate of 8% annually. Now what do these contractual terms mean?

The face amount of the bond determines the amount that the issuers will pay the holder at the end of the life of the bond. In this example, at the end of 10 years, the issuer of the bond will pay to the bondholder $1,000. The "nominal" interest rate, 8%, determines the amount of annual payments that will be made in addition to the terminal payment at the end of the bond term. Since that rate in our example is 8%, the semi-annual payments on the $1,000 bond will be $40. For this reason, when the borrower firm offers this bond for sale, it is asking, "How much will you lend me for promises to pay $40 twice each year for 10 years and, in addition, for the promise that I will pay $1,000 at the end of 10 years?"

The amount that a lender will be willing to offer for a bond is dependent upon the desired rate of interest, or yield, that the lender wishes to earn on the amount about to be invested. Exhibit 3A illustrates the procedure that three investors might us to decide what to bid on a bond offering, assuming that each is willing to earn a different rate of interest on the investment. The lender willing to bid the highest amount determines the prevailing market interest rate for the bonds offered.

The difference between the face amount of the bond and the amount received by the borrower when the bond is initially issued is referred to as the discount or premium. If the amount received is larger than the face amount, the difference is called the premium. If it is smaller, the difference is called the discount. Premium or discount results whenever the nominal interest rate, which is stated on the face of the bond, is different from the current market rate of interest demanded by lenders. Only after a bond is issued can the borrower determine the effective interest rate on the debt. The effective interest rate is the prevailing interest rate determined by the successful bid for the bonds.

The amount of the liability created by issuing a bond includes the premium (or excludes the discount), which will be amortized by the difference between the interest expense each period and the interest payment actually made. At any given time, the liability will be the face amount of the bond plus or minus the unamortized premium or discount created whtn the bond was first sold. From Exhibit 3B, we can surmise that Investor A, who is willing to invest to earn 6% interest, would at any time be willing to allow Eastern Coast Company to buy back the bond for the amount of liability at the beginning of the year, pus current interest not yet paid, plus perhaps a small premium for inconvenience. Near the end of the 10^th year, the amount would be about $1,000 plus current interest earned but not paid.

A similar analysis could be applied to bond discounts, except that the positions would be somewhat different. We can see by referring to Exhibit 3A that if on the day after Eastern Coast had issued the bond to Investor C for $875, eh company wished to cancel the agreement, Investor C probably would have been quite willing to accept $1,000 for the bond. On the other hand, if we assume that other investments offering a 10% interest rate are available and that Investor C would be able to reinvest at 10%. It would not be surprising to find that Investor C would be willing to cancel the future obligations in return for a payment for something near $875 and any current interest already earned but not paid.

Exhibit 3A Analysis of a Bond by Three Investors [A, B, and C]

Eastern Coast Company--- Analysis of Value of 10-year, 8%, $1,000 bonds to three investors who seek 6%, 8%, and 10% return, respectively

Investor A demands 6%

Investor B demands 8%

Investor C demands 10%

Bond contract ("indenture") promises;

a)20 payments of $40 every six months for 10 years

b)1 payment of $1,000 at the end of 10 years

Present Value of $1.00At 6% Interest At 8% Interest At 10% Interest

Received semiannually for 10 years14.877513.590312.4622

Received at end of 10 years.5537.4564, 3769

Value to Investors at Issue Date

ABC

14.8775 X $40 = $595.1013.5903 X $40 = $543.6012.4622 X $40 = $498.49

.5537 X $1,000 = $553.70.4564 X $1,000 = $456.40.3769 X $1,000 =$376.90

Total$1,148.80$1,000.00$875.39

A will pay a $148.80 premiumB will pay the face amountC demands a discount of $124.61

Assume that Eastern Coast Company issued the bond described in Exhibit 3A to investor A and received $1,148.80 from him or her. Investor A has accepted a yield rate of interest of 6%, which is the rate of interest Eastern Coast now will pay on the actual amount borrowed. Its original promises remain constant, however; it will make 20 payments of $40 at the end of each year for 10 years and one payment of $1,000 at the end of 10 years. If the original liability of Eastern Coast is assumed to be equal to the amount received, the table below shows how that liability increases during each year because of the interest owed to Investor A, then falls as each $40 payment is made, until at the end of 10 years it is exactly equal to the $1,000 terminal payment originally promised.

Analysis of 2000 Bond Issue Remaining Liability at reissue date (from case) Bond par value $10,000,000 25 semi-annual pmt @ $400,000 Face Rate 8% payment of $10,000,000 SO Yield 9% # of Payments 40 Semi-Annual Interest Payments $400,000 Re-compute Balances Cash Flows 2007 $9,258,589.55 For 40 payments $0 annuity 2008 $9,292,611.26 For 1 payment in 40th year $0 lump sum payment 50 total value of bond Current Market Value at 6% interest rate $11,541,502.41 Date Year interest payment Bonds Payable Book Value Bond Discount to (stated) (PV) maturity (E-F) 1999 at issue 10,000,000 $9,079,920.78 920,079.22 2-Jan 2000 400,000 10,000,000 $9,088,517.21 911,482.786 AUAWN 2-Jun 2-Jan 2001 2-Jun 2-Jan 2002 2- Jun 2 2-Jan 2003 2-Jun 3 2-Jan 2004 10 2-Jun 11 2-Jan 2005 12 2-Jun 13 2-Jan 2006 14 2-Jun 15 2-Jan 2007 16 2- Jun 17 2-Jan 2008 18 2 - Jun 19 2-Jan 2009 20 2-Jun 21 2-Jan 2010 22 2-Jun 10 23 2-Jan 2011 24 2-Jun 25 2-Jan 2012 26 2-Jun 12 27 2-Jan 2013 28 2- Jun 29 2-Jan 2014 30 2- Jun 14 31 2-Jan 2015 32 2-Jun 15 33 2-Jan 2016 34 2-Jun 16 35 2-Jan 2017 36 2-Jun 17 37 2-Jan 2018 38 2-Jun 18 39 2-Jan 2019 40 2-Jun 19cost of refunding old bonds $11,541,502 at price of 115.415 stated in case proceeds from New Bonds $10,000,000 cash cost of refund the Bonds $1,541,502 Differential Cash Flows 2009 BOY $ $ difference from orignial to new issuance Old New Difference 2-Jun 2009 $400,000 $300,000 100,000 2-Jan 2010 2-Jun 2010 UI A 2-Jan 2011 2-Jun 2011 6 2-Jan 2012 7 2-Jun 2012 8 2-Jan 2013 9 2-Jun 2013 10 2-Jan 2014 11 2-Jun 2014 12 2-Jan 2015 13 2-Jun 2015 14 2-Jan 2016 15 2-Jun 2016 16 2-Jan 2017 17 2-Jun 2017 18 2-Jan 2018 19 2-Jun 2018 20 2-Jan 2019 21 2-Jun 2019Selling enough bonds to retire the entier issue $11,541,502 proceeds from New Bonds $10,000,000 difference $1,541,502 New Bond Issue $10,000,000 New Coupon Payment $300,000 Cash Flows from Refunding Old New Difference the old bond is still paying $400,000 W N 2-Jun 2009 $400,000.00 400,000 2-Jan 2010 $400,000.00 400,000 2-Jun 2010 $400,000.00 400,000 2-Jan 2011 $400,000.00 400,000 5 2-Jun 2011 $400,000.00 400,000 James H. McCann: 2-Jan 2012 $400,000.00 400,000 What is the value of the new coupon 7 2-Jun 2012 $400,000.00 400,000 ipayments based on selling enough 8 2-Jan 2013 $400,000.00 400,000 bonds to retire the $10 million debt offering. 9 2-Jun 2013 $400,000.00 400,000 10 2-Jan 2014 $400,000.00 400,000 11 2-Jun 2014 $400,000.00 400,000 12 2-Jan 2015 $400,000.00 400,000 13 2-Jun 2015 $400,000.00 400,000 14 2-Jan 2016 $400,000.00 400,000 15 2-Jun 2016 $400,000.00 400,000 16 2-Jan 2017 $400,000.00 400,000 17 2-Jun 2017 $400,000.00 400,000 18 2-Jan 2018 $400,000.00 400,000 19 2-Jun 2018 $400,000.00 400,000 20 2-Jan 2019 $400,000.00 400,000 21 2-Jun 2019 $10,400,000.00 -10,400,000