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L ONG-TERM F INANCING B ONDS

CHAPTER 15. L ONG-TERM F INANCING B ONDS. [After listening to the lecture comments for this slide, click anywhere outside the slide to continue.]. Three Ways Corporations Can Raise Cash . Sell Stock Borrow from Bank Borrow from Investors (i.e., Sell Corporate Bonds)

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L ONG-TERM F INANCING B ONDS

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  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. Cash Bond Certificate 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. Interest Payments Every Six Months Face Value Payment at Maturity 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/Home Loan Bond Loan $ $ Principal Payment(at maturity) Level Periodic Payments (Includes principal & interest) Level Periodic Payments (Includes interestonly) Last Pmt. Last Pmt. Time Time 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. P. 547 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 Bond Date 12/31/94 Maturity Date 12/31/99 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. Long-term Liability 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 bond’s interest dates?

  30. Bonds Issued Between Interest Dates When bonds are soldbetweenthe 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. Cash Price of Bonds: $1,000 × 1,000 = $ 1,000,000 Accrued Interest: $1,000,000 × 10% ×3/12 = 25,000 Total Cash Received $ 1,025,000 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/A:Effective 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 > contract rate Bonds sell at a discount (i.e., below face value) • Market rate < 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 bond’s 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 increasethe 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. Illustration 15.3, P. 550(Slightly modified) Assumptions: Face amount (i.e., loan) = $1,000 Length of loan = 1 yr. Market rate = 12% Contract rate = 10% 12% 10% 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.

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