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Question
A debt-for-debt swap of debts with equal maturity values that occurs when the market rate of interest is higher than the stated rate of the old debt will give rise to a gain on debt extinguishments.
Answer
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Perez Company sold equipment to Gomez, receiving in exchange a note that called for three equal annual principal payments of $100,000 plus annual interest payments of $4,000. Because the market rate of interest for companies with Gomez' credit standing was 6% at the time of the sale, Perez correctly recorded the note at its present value of $277,993. After receiving the first payment, Perez learns that the market rate of interest on loans of this type has fallen to 5%. Assume that there is an active market for these types of notes. The present value of $1 to be received n periods in the future = 1 (1 + r)n where r is the rate of interest per period.
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A factor that can reduce managers' short-term focus is the fact that incentive compensation plans are administered by a compensation committee that can intervene when circumstances warrant modification of the scheduled incentive award.
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Because covenant compliance can be jeopardized by mandated changes in accounting principles, many loan agreements have financial covenants that rely on the accounting rules in place when the loan is first granted.
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C. negative restrictions.
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B. borrowers.
C. both lenders and borrowers.
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