Corporate Borrowing: Cash Flow Implications of In-Substance Defeasance

Article excerpt

In an article in the September 1993 issue of be CPA Journal, William J. Coffey and Lewis Schier provided valuable information to companies evaluating long-term financing options. In particular, they discussed the advantages of sinking-fund debentures and in-substance defeasance. In a climate of rising interest rates, in-substance defeasance becomes an attractive option to companies because it results in higher reported earnings and a lower debt-to-equity ratio. As the authors pointed out, this may translate into improved credit ratings.

Companies considering this option, however, should be aware that the income statement and balance sheet benefits of in-substance defeasance may be offset by adverse effects on cash flow.

WHAT IS IN-SUBSTANCE DEFEASANCE?

In-substance defeasance occurs when a firm irrevocably deposits cash or other assets into a trust for the sole purpose of making principal and interest payments on debt as the payments become due. The trust is restricted to owning virtually risk-free securities whose scheduled interest payments and maturity dates roughly coincide in timing and amount with those of the defeased debt. Although the debt is not legally satisfied, the irrevocable trust ensures that the possibility of the firm having to make future payments on the debt is remote.

The advantages of in-substance defeasance are twofold. First, if the defeasance occurs when prevailing long-term interest rates are higher than the rates in effect at the time the debt was issued, the amount of assets necessary to defease the debt typically will be less than its carrying value. This produces a gain, classified as extraordinary in the income statement.

Second, GAAP for in-substance defeasance, which is governed by FASB No. 76, calls for offsetting the trust assets against the defeased debt. The liability is effectively removed from the balance sheet, thereby improving the firm's capital structure.

WHAT ARE THE EFFECTS ON CASH FLOW?

Despite these advantages, in-substance defeasance may not be the best option from a cash-flow perspective. To illustrate this point, the following paragraphs describe the cash-flow consequences of the three typical financing alternatives identified by Coffey and Schier. Although they based their discussion on sinking-fund debt, we use term bonds instead to simplify the calculations involved. Sinking fund bonds would produce similar results.

Each alternative assumes the same debt: $1,000,000 of 6% bonds maturing in 10 years, originally issued at par with interest payable annually. The calculations further assume the current market rate of interest for bonds of firms with a similar credit rating has risen to 7%, while the interest rate on 10-year U.S. treasury bonds stands at 6.5%. Finally, the illustrations assume a corporate tax rate of 35%.

The firm carrying the assumed debt could simply allow it to mature as scheduled. Alternatively, the rise in interest rates makes two other options attractive. The company could either extinguish the debt through repurchase on the open market or employ in-substance defeasance. The cash flows associated with each of these options are summarized below and in the accompanying exhibit. (Exhibit omitted)

Retirement at Maturity. The exhibit shows the present value of the debt-related cash flows if the bonds are allowed to mature. Interest of $60,000 will be paid each year at an after-tax cost of $39,000. When discounted using the current market rate of 7%, the present value of this payment stream together with that of the $1,000,000 payoff at maturity is $782,263. …