LONGTERM FINANCING BONDS

1
CHAPTER 15
LONG-TERM FINANCING BONDS
After listening to the lecture comments for this
slide, click anywhere outside the slide to
continue.
2
Three Ways Corporations Can Raise Cash

• Sell Stock
• Borrow from Bank
• Borrow from Investors (i.e., Sell Corporate
  Bonds)
• Forget U. S. Government Savings Bonds. They are
  very different from corporate bonds.

3
Nature of Bond Transactions

• Never lose sight of the nature of a bond
  transaction!
• Is long-term debt for issuing company
• Is investment for purchasing companies or
  individuals

Seller
Buyer
A/K/A Issuer Borrower
A/K/A Investor Lender
4
Nature of Bond Transactions

• The seller agrees to pay and the buyer expects to
  get
• Periodic interest at specified dates
• Face value (i.e., principal) of bonds at maturity

Seller
Buyer
A/K/A Issuer Borrower
A/K/A Investor Lender
5
Other Types of Loans

• What is the most familiar loan to you?
• Parents

Auto
Home
6
Auto or Home Loan vs.Bond Loan
How does the repayment of an auto or home loan
differ from the repayment of a bond loan?
7
Bonds vs. Stock
BONDS
STOCK
8
Bonds vs. Stock

• BONDS
• Debt

• STOCK
• Equity

9
Bonds vs. Stock

• BONDS
• Debt
• Maturity Date

• STOCK
• Equity
• No Maturity

10
Bonds vs. Stock

• BONDS
• Debt
• Maturity Date
• Interest

• STOCK
• Equity
• No Maturity
• Dividends

11
Bonds vs. Stock

• BONDS
• Debt
• Maturity Date
• Interest
• Bond Interest
• Expense Is
• Deductible for
• Taxes

• STOCK
• Equity
• No Maturity
• Dividends
• Dividends Are Not
• Deductible for
• Taxes

12
Bonds vs. Stock

• Know advantages of issuing debt (p. 545)
• Does not dilute control of company
• Interest is tax deductible
• Favorable financial leverage
• A/K/A Trading on the equity
• Know disadvantages of issuing debt (546)
• Interest must be paid
• Harder to withstand a major loss
• Possibility of unfavorable financial leverage

13
Favorable Financial Leverage(Using borrowed
funds to increase EPS)

• (E.g. borrow at 10 invest at 20)

14
Characteristics of Bonds(PP. 544 - 545)

• Secured or Unsecured Bonds
• Registered or Unregistered Bonds
• Coupon Bonds
• Serial Bonds
• Callable Bonds
• Convertible Bonds
• Bonds with Stock Warrants
• Junk Bonds

15
Bonds Payable Terms
BOND PAYABLE
16
Bonds Payable Terms
Face Value 1,000
BOND PAYABLE
1. Face Value Maturity Value
17
Bonds Payable Terms
Face Value 1,000
Interest 10
BOND PAYABLE
1. Face Value Maturity Value 2. Stated
Interest Rate
18
Bonds Payable Terms
Face Value 1,000
Interest 10
6/30 12/31
BOND PAYABLE
1. Face Value Maturity Value 2. Stated
Interest Rate 3. Interest Payment Dates
19
Bonds Payable Terms
Face Value 1,000
Interest 10
6/30 12/31
BOND PAYABLE
Bond Date 12/31/94
1. Face Value Maturity Value 2. Stated
Interest Rate 3. Interest Payment Dates 4. Bond
Date
20
Bonds Payable Terms
Face Value 1,000
Interest 10
6/30 12/31
BOND PAYABLE
Maturity Date 12/31/99
Bond Date 12/31/94
1. Face Value Maturity Value 2. Stated
Interest Rate 3. Interest Payment Dates 4. Bond
Date 5. Maturity Date
21
Bonds Payable Terms
Face Value 1,000
Interest 10
6/30 12/31
BOND PAYABLE
Maturity Date 12/31/99
Bond Date 12/31/94
1. Face Value Maturity Value 2. Stated
Interest Rate 3. Interest Payment Dates 4. Bond
Date 5. Maturity Date
We also need to know the sale or issue date of
the bond.
22
Bonds Issued at Face Value on Bond Date - Example

• On 12/31/94 Graphics Inc. issues 10 bonds at face
  value. The market interest rate is 10. The
  bonds have the following terms
• Face Value 1,000
• Maturity Date 12/31/99 (5 years)
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/94

Graphics Inc.
23
Bonds Issued at Face Value on Bond Date

• Prepare the journal entry to record the issuance
  of the bonds on 12/31/94.

24
Bonds Issued at Face Value on Bond Date

• Prepare the journal entry to record the issuance
  of the bonds on 12/31/94.

25
Bonds Issued at Face Value on Bond Date

• Prepare the journal entry required every 6/30 and
  12/31 to pay interest.

26
Bonds Issued at Face Value on Bond Date

• Prepare the journal entry required every 6/30 and
  12/31 to pay interest.

27
Bonds Issued at Face Value on Bond Date

• Prepare the journal entry to record the maturity
  of the bond on 12/31/99.

28
Bonds Issued at Face Value on Bond Date

• Prepare the journal entry to record the maturity
  of the bond on 12/31/99.

29
Bonds Issued Between Interest Dates

• In the previous example, the bonds were sold
  on the bond date.
• But this is not always the case.
• Are you ready to see what happens when we sell
  bonds between the bonds interest dates?

30
Bonds Issued Between Interest Dates

• When bonds are sold between the interest dates,
  the bond issuer collects cash for
• The face value of the bonds
• AND
• The accrued interest since the bonds date

31
Bonds Issued Between Interest Dates

• Then, on the next interest payment date, the bond
  issuer pays bondholders a full 6 months of
  interest.

32
Bonds Issued Between Interest Dates

• The 6 month interest payment to the bondholders
  is composed of
• Repayment of the interest received from the
  bondholders when the bonds were originally sold
• AND
• Interest earned by the bondholders since the
  bonds were sold

Why is it done this way?
33
Bonds Issued Between Interest Dates - Example

• On 4/1/95 Graphics Inc. issues 1,000 bonds at
  face value. The bonds have the following terms
• Face Value 1,000
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/94
• Maturity Date 12/31/99 (5 years)

Graphics Inc.
34
Bonds Issued Between Interest Dates

• How much cash is Graphics Inc. going to receive
  for the entire issue of the bonds?

35
Bonds Issued Between Interest Dates

• What does the 25,000 in accrued interest
  represent for Graphics Inc.?

Interest Payable
36
Bonds Issued Between Interest Dates

• Prepare the journal entry to record the bond
  issue on 4/1/95.

37
Bonds Issued Between Interest Dates

• Prepare the journal entry to record the bond
  issue on 4/1/95.

38
Bonds Issued Between Interest Dates

• Prepare the journal entry to record the bond
  interest payment on 6/30/95.

39
Bonds Issued Between Interest Dates

• Prepare the journal entry to record the bond
  interest payment on 6/30/95.

Bond Interest Expense is for the three months
April, May, and June. (1,000,000 10
3/12 25,000)
40
Bonds Issued Between Interest Dates

• Prepare the journal entry to record the bond
  interest payment on 6/30/95.

Total Bond Interest Paid is for the six months
January through June (1,000,000 10 6/12
50,000)
41
Bonds Issued Between Interest Dates

• Prepare the journal entry to record the bond
  interest payment on 6/30/95.

The debit to Bond Interest Payable is for the
accrued interest that was collected when the
bonds were sold.
42
Interesting Terminology

• The two sets of interest terms used with bonds
  are

Market Rate - A/K/AEffective Rate Yield
Rate APR "True" Rate Compound Rate

• Contract Rate - A/K/A
• Stated Rate
• Coupon Rate
• Nominal Rate
• Face Rate
• Simple Rate

43
Bond Prices and Interest Rates

• Market rate contract rate
• Bonds sell at face or par value
• Market rate gt contract rate
• Bonds sell at a discount
• (i.e., below face value)
• Market rate lt contract rate
• Bonds sell at a premium
• (i.e., above face value)

44
Market Interest Rate vs.Contract Interest Rate
Click one
YES!
NO!
What happens when the market interest rate is
different from the bonds contract interest rate?
For example, the market is earning 12. Would
you want to invest in Graphics Inc.s 10 bond?
45
Market Interest Rate vs.Contract Interest Rate

• How could Graphics Inc. make their bonds more
  attractive to you?
• They cannot change any terms of the bonds
  payable.
• The only thing they can change is the selling
  price of the bonds.

46
Market Interest Rate vs.Contract Interest Rate

• So, if the bond is paying 10 interest and the
  market is paying 12 interest, Graphics Inc.
  would
• Sell the bond below face value(i.e., at a
  discount)
• BUT
• Pay interest on the full face value
• AND
• Repay the full face value at maturity

47
Market Interest Rate vs.Contract Interest Rate

• This arrangement will increase the effective
  interest rate of Graphics Inc. bonds to the
  market rate.

Therefore, Graphics Inc.s 10 bonds would be
just as attractive as the market investments
earning 12. How can this happen? (Proof is on
next slide)
48
Market Interest Rate vs.Contract Interest Rate
Proof of Concept
49
Market Interest Rate vs.Contract Interest Rate
Proof of Concept
Assumptions Face amount (i.e., loan)
1,000 Length of loan 1 yr.
Market rate 12
Contract rate 10
Interest Principal x Rate x Time 100
P x .12 x 1 P
833 1,000 x 10 contract rate
50
Bonds Sold at a Discounton Bond Date

• On 12/31/94 Graphics Inc. sells 1,000 bonds at
  92.6395 of face value. The market interest rate
  is 12. The bonds have the following terms
• Face Value 1,000
• Maturity Date 12/31/99 (5 years)
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/94

Graphics Inc.
51
Bonds Sold at a Discount

• How much cash is Graphics Inc. going to receive
  for the entire bond issue?

52
Bonds Sold at a Discount
How much cash is Graphics Inc. going to receive
for the entire bond issue? 1,000 face value
1,000 bonds sold 1,000,000 face
amount 1,000,000 92.6395 926,395 cash
proceeds How much does Graphics Inc. agree to
repay at maturity?
53
Bonds Sold at a Discount

• Graphics Inc. agrees to repay the full face value
  at maturity.
• 1,000 face value 1,000 bonds sold 1,000,000

54
Bonds Sold at a Discount
The difference between the face value of the
bonds and the cash received is the
discount. 1,000,000 - 926,395 73,605 The
discount causes additional interest expense
factor for Graphics Inc but does not affect
interest paid. The discount will be amortized to
Bond Interest Expense over the outstanding life
of the bonds.
55
Bonds Sold at a Discount

• Prepare the journal entry to record the issue of
  the bonds on 12/31/94.

56
Bonds Sold at a Discount

• Prepare the journal entry to record the issue of
  the bonds on 12/31/94.

57
Bonds Sold at a Discount

Discount on Bonds Payable
12-31 bal. 73,605
58
Bonds Sold at a Discount
Partial Balance Sheet at 12/31/94
Long-term Liabilities
Bonds Payable
1,000,000


Less Discount on Bonds Payable
73,605


926,395


59
Bonds Sold at a Discount
Definition of Carrying Value? Face/Maturity
Value - unamortized discount (current
example) or unamortized premium (later example)
60
Bonds Sold at a Discount

• Prepare the journal entries required every 6/30
  and 12/31. Use straight-line amortization of the
  discount.

Effective interest method will be discussed later
in the lecture.
61
Bonds Sold at a Discount
GENERAL JOURNAL
Page 1
Date
Description
PR
Debit
Credit
6/30
Bond Interest Expense
57,360
Discount on Bonds Payable
7,360
Cash

50,000
To record bond interest payment
1,000,000 10 ½ 50,000
To record discount amortization
73,605 5 yrs. 14,721 per year
14,721 2 7,360 rounded
62
Bonds Sold at a Discount

Discount on Bonds Payable
12-31 bal. 73,605
63
Bonds Sold at a Discount
As the discount is amortized, the carrying value
of the bonds payable increases toward the
maturity value. (i.e. we subtract a smaller and
smaller contra account on the B/S.)
64
Bonds Sold at a Discount
Down from 73,605
Up from 926,395
65
Compound Interest Concepts
Before we go any further, lets make sure we
understand the compound interest concepts in the
appendix!
66
Compound Interest ConceptsExample 1
Future Value (Worth) of 1
Example is related to Illustration 15-6 Interest
Rate 12 No. Periods 2 years
- 1.2544 (From Table A.1)
1
- ?
1,000
- X
1 1.2544
1,000
X X 1,254.40
67
Compound Interest ConceptsExample 2
Future Value of an Annuity of 1
Example is related to Illustration 15-7 Interest
Rate 6 No. Periods 3
- 3.1836 (From Table A.2)
1 1
1 - ?
100 100
100 - X
1 3.1836
100
X X 318.36
68
Compound Interest ConceptsExample 3
Present Value (Worth) of 1
Two PerspectivesTextRice
69
Compound Interest ConceptsExample 3
Present Value (Worth) of 1
Example is related to Illustration 15-8 Interest
Rate 12 No. Periods 2 years
.7972 (From Table A.3)
?
- 1
X
- 1,000
.7972 1 .

X 1,000 X
797.20
70
Compound Interest ConceptsExample 4
Present Value of an Annuity of 1
Example is related to Illustration 15-9 Interest
Rate 6No. Periods 3
2.673 (From Table A.4)
? - 1
- 1 - 1
X - 100
- 100 - 100
2.673 1 .

X 100 X
267.30
71
So, What Does All of This Have to do With Bonds?
The bond investor is buying the right to receive
two things
X - The present value of the maturity amount of
the bonds (i.e., the face amount)
Y - The present value of the periodic bond
interest payments
72
So, What Does All of This Have to do With Bonds?
Example below uses data from bottom p. 550
Facts Interest Rate 6 No. Periods
6 Maturity/Face Amount 100,000
QUESTION This bond was sold at a (click one)

Premium
Discount
Face Amount
X

- 100,000
70,496
Y - 6,000 - 6,000 -
6,000 - 6,000 - 6,000 - 6,000
29,504
A/K/A, the cost to the investor and
the proceeds to the issuer.
100,000
Z Total Present Value of Bonds
(i.e., Total Market Price)
73
Bonds Sold at a Discount
Lets apply what we just learned.
74
Bonds Sold at a Discount
NOTE The 926,395 selling price of the bonds on
the next slide was previously calculated on slide
52 as a simple percentage of face amount. The
current calculation is a conceptual one which
builds on the present value concepts in the
appendix and on the last few slides. A
calculation of bond selling price will be on the
next test.
Calculate how Graphics, Inc. would determine the
selling price of its bonds.
75
Bonds Sold at a Discount
Face Value
1,000,000


Stated Interest Rate
10
Facts
Number of Periods (5 yrs. 2)
10

Market Interest Rate
12
Present Value of Bonds on Issuance Date

76
Market Interest Rate vs.Contract Interest Rate
(again)
Click one
YES!
NO!
Now, what happens when the market interest
rates are lower than the bonds contract
interest rate? For example, the market is earning
8. Would you want to invest in Graphics Inc.s
10 bond?
77
Market Interest Rate vs.Contract Interest Rate

• So, if the bond is paying 10 interest and the
  market is paying 8 interest, Graphics Inc.
  would
• Sell the bond above face value
  (i.e., at a premium)
• BUT
• Pay interest on only the face value
• AND
• Repay only the face value at maturity

78
Market Interest Rate vs.Contract Interest Rate
Based on the logic explained earlier, this
arrangement will decrease the effective interest
rate of Graphics Inc. bonds to the market rate.
Therefore, Graphics Inc.s 10 bonds would
provide a return to the investor/lender equal to
the markets 8.
79
Bonds Sold at a Premium

• On 12/31/94 Graphics Inc. sells 1,000 bonds at
  108.1105 of face value. The market interest
  rate is 8. The bonds have the following terms
• Face Value 1,000
• Maturity Date 12/31/99 (5 years)
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/94

Graphics Inc.
80
Bonds Sold at a Premium

• How much cash is Graphics Inc. going to receive
  for the entire bond issue?

81
Bonds Sold at a Premium

• How much cash is Graphics Inc. going to receive
  for the entire bond issue?
• 1,000 face value 1,000 sold 1,000,000
  face amount
• 1,000,000 108.1105 1,081,105 cash proceeds

82
Bonds Sold at a Premium

• How much does Graphics Inc. agree to repay at
  maturity?
• 1,000 face value 1,000 sold 1,000,000
• How much cash interest does Graphics Inc. agree
  to pay at each interest date?
• 1,000,000 10 contract rate 6/12
  
  50,000

This is the cash amount which will be paid
regardless of whether the bonds were issued at
face, a discount or a premium!
83
Bonds Sold at a Premium

• In this case, the difference between the face
  value of the bonds and the cash received is the
  premium.
• 1,081,105 - 1,000,000 81,105
• The premium causes a reduction in the interest
  expense for Graphics but not in the interest
  paid. The premium will be amortized to bond
  interest expense over the life of the bonds.

84
Bonds Sold at a Premium

• Prepare the journal entry to record the issue of
  the bonds on 12/31/94.

85
Bonds Sold at a Premium

• Prepare the journal entry to record the issue of
  the bonds on 12/31/94.

86
Bonds Sold at a Premium

Premium on Bonds Payable
81,105 Bal. 12-31
87
Bonds Sold at a Premium
Partial Balance Sheet at 12/31/94
Long-term Liabilities
Bonds Payable
1,000,000




Add
Premium on Bonds Payable
81,105


1,081,105


Maturity Value
Carrying Value
88
Bonds Sold at a Premium

• Prepare the journal entries required every 6/30
  and 12/31. Use straight-line amortization of the
  premium.

Again, effective interest method will be
discussed later in lecture.
89
Bonds Sold at a Premium
90
Bonds Sold at a Premium

Premium on Bonds Payable
81,105 Bal. 12-31
91
Bonds Sold at a Premium
92
Bonds Sold at a Premium
As the premium is amortized, the carrying value
of the bonds payable decreases toward the
maturity value. (i.e. we add a smaller and
smaller adjunct account on the B/S.)
93
Bonds Sold at a Premium
Again, lets calculate how Graphics, Inc. would
determine the selling price of the bonds.
The 1,081,105 selling price of the bonds on the
following slide was previously calculated on
slide 81 as a simple percentage of face amount.
As before, the following calculation is a
conceptual one which builds on present value
concepts in the appendix.
94
Bonds Sold at a Premium
Face Value
1,000,000


Stated Interest Rate
10
Facts
Number of Periods (5 yrs. 2)
10

Market Interest Rate
8
Present Value of Bonds on Issuance Date
95
Examples of Simple Sales Entries
Sold at Face Cash
1,000 Bonds Payable
1,000
Sold at Discount Cash
900 Discount on Bonds Payable
100 Bonds Payable
1,000
Sold at Premium Cash
1,100 Premium on Bonds Payable
100 Bonds Payable
1,000
96
Methods of AmortizationStraight-Line vs.
Effective Interest

• Which is preferred for GAAP?
• Effective interest method
• So, when can straight-line be used?
• When the results are not materially
  different from the effective interest method.
• How do the two methods differ?

97
Methods of AmortizationStraight-Line vs.
Effective Interest

• Conceptual difference given a discount
  situation.

Straight-line
Effective Interest
?


?
Time
Time
98
Methods of AmortizationStraight-Line vs.
Effective Interest

• Conceptual difference given a discount
  situation.

Straight-line
Effective Interest
CV


Int . Exp.
Time
Time
99
Effective Interest Method(For Either Premium or
Discount)

• Calculate bond interest expense at the date of
  each semiannual interest payment as follows
• Bond interest expense Carrying value of bond
  at beginning of period X Market/effective/yield
  rate of interest X 6/12
• The amortization amount, then, is simply the
  difference between the interest expense and the
  cash interest payment.

100
Effective Interest MethodDiscount Example

• From an earlier example, Graphics Inc. sold 10
  bonds with a face value of 1,000,000 for
  926,395. Market rate 12.
• Amortization entry 6 months later
• Bond Interest Expense 55,584
• Cash (1,000,000 x .10 x 6/12)
  50,000
• Discount on Bonds Payable
  5,584
• (926,395 x .12 X 6/12)
• To do the next amortization entry, one ideally
  needs what?

101
Effective Interest Method Discount Amortization
Table
(A)
(B)
(C)
(D)
(E)
Interest
Interest
Discount
Unamortized
Carrying
Date
Payment
Expense
Amortization
Discount
Value
1/1/95
73,605


926,395


6/30/95
50,000


55,584


5,584


68,021


931,979


12/31/95
50,000


55,919


5,919


62,102


937,898


A 1,000,000 10 ½ 50,000
B 931,979 6 55,919
C 55,919 - 50,000 5,919
D 68,021 - 5,919 62,102
E 1,000,000 - 62,102 937,898
102
Effective Interest MethodDiscount Amortization
Table
(A)
(B)
(C)
(D)
(E)
Interest
Interest
Discount
Unamortized
Carrying
Date
Payment
Expense
Amortization
Discount
Value
1/1/95
73,605


926,395


6/30/95
50,000


55,584


5,584


68,021


931,979


12/31/95
50,000


55,919


5,919


62,102


937,898


6/30/96
50,000


56,274


6,274


55,828


944,172


12/31/96
50,000


56,650


6,650


49,178


950,822


6/30/97
50,000


57,049


7,049


42,129


957,871


12/31/97
50,000


57,472


7,472


34,657


965,343


6/30/98
50,000


57,921


7,921


26,736


973,264


12/31/98
50,000


58,396


8,396


18,340


981,660


6/30/99
50,000


58,900


8,900


9,440


990,560



12/31/99
50,000


59,434


9,440


0
1,000,000

Adjusted.
103
Effective Interest MethodPremium Example

• From an earlier example, Graphics Inc. sold 10
  bonds with a face value of 1,000,000 for
  1,081,105. Market rate 8.
• Amortization entry 6 months later
• Bond Interest Expense 43,244
• Premium on Bonds Payable 6,756
• Cash (1,000,000 x .10 x 6/12)
  50,000
• (1,081,105 x .08 X 6/12)

And now, the amortization table...
104
Effective Interest Method Premium Amortization
Table
(A)
(B)
(C)
(D)
(E)
Interest
Interest
Premium
Unamortized
Carrying
Date
Payment
Expense
Amortization
Premium
Value
1/1/95
81,105


1,081,105


6/30/95
50,000


43,244


6,756


74,349


1,074,349


12/31/95
50,000


42,974


7,026


67,323


1,067,323


A 1,000,000 10 ½ 50,000
B 1,074,349 4 42,974
C 50,000 - 42,974 7,026
D 74,349 - 7,026 67,323
E 1,000,000 67,323 1,067,323
105
Effective Interest Method Premium Amortization
Table
(A)
(B)
(C)
(D)
(E)
Interest
Interest
Premium
Unamortized
Carrying
Date
Payment
Expense
Amortization
Premium
Value
1/1/95
81,105


1,081,105


6/30/95
50,000


43,244


6,756


74,349


1,074,349


12/31/95
50,000


42,974


7,026


67,323


1,067,323


6/30/96
50,000


42,693


7,307


60,016


1,060,016


12/31/96
50,000


42,401


7,599


52,417


1,052,417


6/30/97
50,000


42,097


7,903


44,514


1,044,514


12/31/97
50,000


41,781


8,219


36,295


1,036,295


6/30/98
50,000


41,452


8,548


27,747


1,027,747


12/31/98
50,000


41,110


8,890


18,857


1,018,857


6/30/99
50,000


40,754


9,246


9,611


1,009,611



12/31/99
50,000


40,389


9,611


0


1,000,000


Rounded
106
Redeeming (Paying Off)Bonds Payable

• When they mature, make the simple entry
• Bonds Payable (DEBIT)
• Cash (CREDIT)
• If paid before maturity
• Compare carrying value of the bonds with the cash
  paid to retire the bonds
• If retirement price lt carrying value, have gain
• If retirement price gt carrying value, have loss
• Is a loss a debit or credit?

Debit
Credit

• Gain or loss reported where?
• Early extinguishment (retirement) of debt
  (Chap.13)

107
Bond Redemption Sinking Fund
May be required by bond indenturei.e., contract
Fund is used to redeem bonds and pay interest
Sinking Fund
Classified as Investments or Other Assets
108
Have we bitten off more than we can chew?
Kmbekibek