Analyzing Debt Terms, Yields, Prices, and Credit Ratings Assume Reproduced below
ID: 2711997 • Letter: A
Question
Analyzing Debt Terms, Yields, Prices, and Credit Ratings
Assume Reproduced below is the long-term debt footnote from the 10-K report of Southwest Airlines.
* The carrying value of these debentures is 103 while the face value is 100. The company marks these debentures to market each period because the debentures are hedged with interest-rate swaps. The swap and the debentures are both marked to market, where any gains and losses offset each other.
As of December 31, 2012, aggregate annual principal maturities of debt and capital leases (not including amounts associated with interest rate swap agreements and interest on capital leases) for the five-year period ending December 31, 2017, were $45 million in 2013, $40 million in 2014, $55 million in 2015, $38 million in 2016, $416 million in 2017, and $1.5 billion thereafter.
Assume below is a summary of the market values of the Southwest Airlines' bonds maturing from 2017 to 2032 (from Capital IQ).
What are the scheduled maturities for this indebtedness? Year ($ millions)
Why is information relating to a company's scheduled maturities of debt useful in an analysis of its financial condition?
We prefer to see liabilities coming due in the near future if interest rates are expected to decline; but deferred if interest rates are expected to increase.
We are looking to see if all payments are approximately equal. If so, the expected drain on cash flow will be constant.
The information relating to a company's scheduled maturities is not important.
(b) Southwest reported $119 million in interest expense in its 2012 income statement. In the note to its statement of cash flows, Southwest indicates that the cash portion of this expense is $63 million. What could account for the difference between interest expense and interest paid?
The difference arises because the amount of interest paid is based on prevailing interest rates that change frequently.
There is never any difference between interest expense and interest paid.
The difference arises because the amount of interest expense is based on prevailing interest rates that change frequently.
(c) Southwest's long-term debt is rated "BBB+" by Fitch and similarly by other credit rating agencies. What factors would be important to consider in attempting to quantify the relative riskiness of Southwest compared with other borrowers?
Credit rating agencies assess companies' default risk by focusing primarily on non-quantitative measures such as the quality of the company's management team.
Credit rating agencies assess companies' default risk by focusing primarily on macroeconomic factors such as the projected level of interest rates.
Credit rating agencies assess companies' default risk by comparing the target company against companies that have defaulted on their debt.
($ million)
How is the difference between this market value and the $370 million face value reflected in Southwest's financial statements?
The balance sheet is unaffected, but the income statement reflects increases (decreases) in interest rates as increases (decreases) in interest expense.
Only the statement of cash flows is affected as cash is needed to retire the liabilities when they mature.
The current market value of the notes is reflected in the balance sheet as an increase (decrease) in liabilities if rates have declined (increased).
What effect would the repurchase of this entire note issue have on Southwest's financial statements?
There would be no effect on the financial statements if Southwest were to repurchase these notes because the repurchase would be made at book value.
Only the balance sheet and statement of cash flows would be affected as they reflect the cash payment and consequent reduction of liabilities.
Southwest is prohibited from repurchasing the notes before maturity and, thus, no financial statements would be affected.
What does the 97.290 price tell us about the general trend in interest rates since Southwest sold this bond issue?
The market price of the debt relates only to investor's expectations about the general condition of the airline industry and is unaffected by the level of interest rates.
Because these notes have declined in value subsequent to their issuance, market interest rates must have decreased.
The price of the bonds is unrelated to the general level of interest rates, only the rate of interest on Southwest's debt. Because that hasn't changed, other causes must be considered.
Long-Term Debt (in millions) 2012 2011 7 7/8% Notes due 2012 $ -- $ 100 French Credit Agreements due 2017 50 37 6 1/2% Notes due 2017 370 369 5 1/4% Notes due 2019 350 336 5 3/4% Notes due 2021 300 300 5 1/8% Notes due 2022 311 300 French Credit Agreements due 2022 94 100 Pass Through Certificates 480 -- 7 3/8% Debentures due 2032 103* 100 Capital leases 52 63 2,110 1,705 Less current maturities 45 122 Less debt discount and issuant costs 19 16 $ 2,046 $ 1,567Explanation / Answer
Why is information relating to a company's scheduled maturities of debt useful in an analysis of its financial condition?
Answer: Excessive payments in any one year can create a cash flow problem, especially if the debt cannot be refinanced.
(b) Southwest reported $119 million in interest expense in its 2012 income statement. In the note to its statement of cash flows, Southwest indicates that the cash portion of this expense is $63 million. What could account for the difference between interest expense and interest paid?
Answer:The difference arises from the amortization of any discounts or premiums on the debt.
(c) Southwest's long-term debt is rated "BBB+" by Fitch and similarly by other credit rating agencies. What factors would be important to consider in attempting to quantify the relative riskiness of Southwest compared with other borrowers?
Answer: Credit rating agencies assess companies' default risk by gauging the level of debt in relation to the companies' operating cash flow, profitability ratios, and the ratios for long-term creditworthiness.
(d) Southwest's $370 million 6.5% notes traded at 97.290, or 97.29% of par, as of December 2013. What is the market value of these notes on that date? (Round your answer to one decimal place.)
Answer:=$370*97.29%=$359.973 million
How is the difference between this market value and the $370 million face value reflected in Southwest's financial statements?
Answer:The current market value of the notes is not reflected in Southwest's balance sheet.
What effect would the repurchase of this entire note issue have on Southwest's financial statements?
Answer: If Southwest were to repurchase these notes, the difference would be reported as a gain in the current income statement.
What does the 97.290 price tell us about the general trend in interest rates since Southwest sold this bond issue?
Answer: Because these notes have declined in value subsequent to their issuance, market interest rates must have increased.