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Chapter 15: Bonds Payable and Investments in Bonds

Chapter 15: Bonds Payable and Investments in Bonds. Instructor’s Lecture. P.H. Financing Corporations. Corporations may finance operations by issuing stocks (equity financing) or bonds (debt financing)

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Chapter 15: Bonds Payable and Investments in Bonds

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  1. Chapter 15: Bonds Payable and Investments in Bonds Instructor’s Lecture P.H.

  2. Financing Corporations • Corporations may finance operations by issuing stocks (equity financing) or bonds (debt financing) • One of the many factors that influence the decision is the effect of each alternative on earnings per share

  3. Financing Corporations • Assume a corporation needs to raise $4,000,000, and they estimate that their earnings before interest on bonds and taxes is $800,000 • Let’s look at estimated income statements based on three alternative financing plans: Plan 1: 100% financing from issuing common stock, $10 par Plan 2: 50% financing from issuing 9% preferred stock, $50 par 50% financing from issuing common stock, $10 par Plan 3: 50% financing from issuing 12% bonds 25% financing from issuing 9% preferred stock, $50 par 25% financing from issuing common stock, $10 par

  4. Financing Corporations: Plan 1100% from $10 par Common Stock

  5. Financing Corporations: Plan 250% from pfd. 9% stock, $50 par50% from common stock, $10 par

  6. Financing Corporations: Plan 350% from 12% bonds25% from pfd. 9% stock, $50 par25% from common stock, $10 par

  7. Financing Corporations • As earnings before bond interest and taxes rises above $800,000, Plan 3 looks even better for the common stockholders

  8. Financing Corporations • Why does Plan 3 (issuing bonds) maximize earnings per share?

  9. Financing Corporations • Plan 3 maximizes earnings per share for common stockholders for 2 reasons: • bond interest payments lower taxes • with less shares of common stock, there is more to distribute to each share (the earnings per share denominator is lower)

  10. Financing Corporations • Will issuing bonds always result in the maximum amount of earnings per share for the common stockholders?

  11. Financing Corporations • Follow the example in the text when the earnings before interest and taxes are only $440,000 • With this lower amount of earnings before interest and taxes, Plan 1 maximizes earnings per share for common stockholders

  12. Financing Corporations: Summary • As earnings before bond interest and taxes rises, bond financing becomes more desirable in terms of maximizing earnings per share • As earnings before bond interest and taxes falls, bond financing becomes less desirable in terms of maximizing earnings per share

  13. Financing Corporations: Summary • Bond financing is riskier than equity financing for the issuing corporation because periodic interest payments and repayment of the face value of the bonds are legal obligations of the company

  14. Characteristics of Bonds Payable • The contract between the corporation and the bondholders is called the bond indenture • The face value (principle) of bonds is usually $1,000, or multiples of $1,000 • Most bonds pay interest semiannually • When all the bonds of an issue mature (are due) at the same time, they are term bonds • If the maturities are spread over several dates, they are serial bonds • Bonds that may be exchanged for other securities, such as common stock, are called convertible bonds • Bonds that a corporation has the right to redeem (buy back) before their maturityare callable bonds

  15. Characteristics of Bonds Payable • When a corporation issues bonds, the price that buyers are willing to pay for the bonds depends on the following three factors: • the face amount (or principle), which is the amount due at maturity (usually $1,000) • the periodic interest to be paid (printed on the bond)—called the coupon rate, or contract rate • the market rate (also called the effective rate) of interest on bonds of similar quality

  16. Characteristics of Bonds Payable • Why would the contract rate be different than the market rate?

  17. Characteristics of Bonds Payable • Because market rates may fluctuate on a daily basis. • The contract rate is the rate that is printed on the bond (it is the rate promised to the bondholders by the corporation). • By the time the bonds reach the market, it is very possible that the market rate has changed.

  18. Characteristics of Bonds Payable • Remember: the contract rate is the same as the coupon rate and the market rate is the same as the effective rate of interest

  19. Characteristics of Bonds Payable • When the coupon rate = (is equal to) the market rate, the bonds will sell at their face amount • When the coupon rate < (is less than) the market rate, the bonds will sell at a discount (less than face amount) • When the coupon rate > (is greater than) the market rate, the bonds will sell at a premium (more than face amount)

  20. Characteristics of Bonds Payable • Why is this true?

  21. Characteristics of Bonds Payable • Let’s assume you were deciding between investing in bonds of Company A, or the bonds of Company B, two companies with the same bond rating. • If Company A had a higher contract rate than Company B, you would choose Company A, all other factors being equal, because you would earn a higher amount of interest with Company A. • What would entice you to invest in the bonds of Company B?

  22. Characteristics of Bonds Payable • You might invest in the bonds of Company B if you could buy the bonds at a discount (an amount less than face value). • Keep in mind that this means you are able to buy the bonds at less than face value (i.e., less than $1,000), but you still receive $1,000 back at maturity.

  23. Characteristics of Bonds Payable • Similarly, bonds sell at a premium because their contract rate is higher than the market rate. • In this case, you pay more than the face amount (i.e., more than $1,000) to purchase the bonds, but you still get only $1,000 back at maturity. • Why would you purchase these bonds? • Because you earn more interest than you would earn on bonds of similar quality.

  24. The Present-Value Concept • The time value of money concept recognizes that an amount of cash to be received today is worth more than the same amount to be received in the future. • If you had the money today, you could invest it at a given rate of interest, and it would grow to be more than its present value (value today).

  25. The Present-Value Concept • In order to understand the concept of present value, let’s review the concept of future value: If I have $100 today (the present value), what will it grow to be (future value) if I can invest it for one year at 7%? $100 X 1.07 = $107 present value 1 + the interest rate future value

  26. The Present-Value Concept • What will it grow to be if I invest it for two years? $107 X 1.07 = $114.49 • Note that I start with the future value after one year ($107) and multiply this by 1 + .07 to get the future value at the end of two years.

  27. The Present-Value Concept • I use $107 because I am earning interest not only on the principle ($100), but also on the interest. • Earning interest on interest is called “compounding” • If I am going to invest for more than 2 years, I can do successive calculations multiplying the previous year’s future value by 1.07. • Or, I can use a future value table.

  28. The Present-Value Concept • For example, if I invest the $100 for 10 years at 7%, I can use the future value table in Appendix A of the text to determine what the $100 will grow to by the end of the 10th year. • Look on page A-6, and find the factor of 1.96715 where the 10 (n\i) meets the 7%. • Multiply the factor (1.96715) by $100 (the present value) to get a future value of $196.15*. *I will have almost doubled my money! I should have invested more than $100!

  29. The Present-Value Concept • Now, let’s try to solve for present value. • Let’s say you plan to go on a cruise with your friends 3 years from now (after you graduate), and you will need to have $3,000 for this cruise. • How much will you need to invest now in order to have $3,000 three years from now? • in order to answer this question, you will need to know how much you can earn on your investment (the interest rate)

  30. The Present-Value Concept • In this case, you already know the future value ($3,000); what you need to know is the present value (how much you need to invest today in order to have $3,000 in three years). • Let’s assume you can earn 7% on your investment. • We can use the mathematical approach by doing successive divisions.

  31. The Present-Value Concept ? X 1.07 = $3,000 When you solve for the unknown number (the present value) using algebra, you end up dividing $3,000 (the future value) by 1 + the interest rate. present value 1 + the interest rate future value

  32. The Present-Value Concept $3,000 1.07 $2,803.74 1.07 $2,620.32 1.07 $2,803.74(rounded) 1 year: 2 years: $2,620.32 (rounded) 3 years: $2,448.90 (rounded)

  33. The Present-Value Concept • You would need to invest $2,448.90 today at 7% to have $3,000 in 3 years. • If you use the present value table in your text (page A-2) you should find the factor of .81630 where the n\i of 3 meets the 7% column. • When you multiply the factor of .81630 by $3,000, you get a present value of $2,448.90.

  34. The Present-Value Concept and Bonds Payable • What does the concept of present value have to do with bonds payable?

  35. The Present-Value Concept and Bonds Payable • The face amount of the bonds and the periodic interest on the bonds represent cash to be received by the buyer in the future. • The buyer determines how much to pay for the bonds by computing the present value of these future cash receipts using the market rate of interest.

  36. Accounting for Bonds PayableBonds Issued at Face Amount • Assume that on January 1, 2002, a corporation issues for cash $100,000 of 12% (contract rate), five-year bonds, at a market (effective) interest rate of 12%. • Since the contract (coupon) rate of 12% is equal to the market (effective) rate of 12%, the bonds will sell at face value ($100,000).

  37. Accounting for Bonds PayableBonds Issued at Face Amount *find this factor in the present value of $1 table where 10 periods intersects with 6%. Use 10 periods because, although it is a 5-year bond, interest is compounded semiannually. Use 6% because the 12% market rate is an annual rate, so the interest rate for 6 months is half of 12%. **the amount of the interest payment is calculated based on the contract rate of 12%. Since it is a semiannual payment, 6% of 100,000 will be paid to bondholders every 6 months. ***Find this factor in the present value of an annuity table where 10 periods intersects with 6%.

  38. Accounting for Bonds PayableBonds Issued at Face AmountJournal Entries: Issuance

  39. Accounting for Bonds PayableBonds Issued at Face AmountJournal Entries: First payment of interest Amount of interest to be paid = 6% (.06) x $100,000

  40. Accounting for Bonds PayableBonds Issued at a Discount • If the market rate of interest is 13% and the contract rate is 12% on the 5-year, $100,000 bonds, the bonds will sell at a discount.

  41. Accounting for Bonds PayableBonds Issued at a Discount *find this factor in the present value of $1 table where 10 periods intersects with 6 1/2%. Use 10 periods because, although it is a 5-year bond, interest is compounded semiannually. Use 6 1/2% because the 13% market rate is an annual rate, so the interest rate for 6 months is half of 13%. **the amount of the interest payment is calculated based on the contract rate of 12%. Since it is a semiannual payment, 6% of 100,000 will be paid to bondholders every 6 months. ***Find this factor in the present value of an annuity table where 10 periods intersects with 6 1/2%.

  42. Accounting for Bonds PayableBonds Issued at a DiscountJournal Entries: Issuance *$3,594 = $100,000 – $96,406

  43. Accounting for Bonds PayableBonds Issued at a DiscountJournal Entries: First payment of interest *The interest expense is greater than $6,000 because the company only received $96,406, but they have to pay back $100,000 **$3,594 (the total discount) /10 periods ***Amount of interest to be paid = 6% (.06) x $100,000

  44. Accounting for Bonds PayableBonds Issued at a Discount • If the market rate of interest is 11% and the contract rate is 12% on the 5-year, $100,000 bonds, the bonds will sell at a premium.

  45. Accounting for Bonds PayableBonds Issued at a Premium *find this factor in the present value of $1 table where 10 periods intersects with 5 1/2%. Use 10 periods because, although it is a 5-year bond, interest is compounded semiannually. Use 5 1/2% because the 11% market rate is an annual rate, so the interest rate for 6 months is half of 11%. **the amount of the interest payment is calculated based on the contract rate of 12%. Since it is a semiannual payment, 6% of 100,000 will be paid to bondholders every 6 months. ***Find this factor in the present value of an annuity table where 10 periods intersects with 5 1/2%.

  46. Accounting for Bonds PayableBonds Issued at a PremiumJournal Entries: Issuance *$3,769 = $103,769 - $100,000

  47. Accounting for Bonds PayableBonds Issued at a PremiumJournal Entries: First payment of interest *The interest expense is less than $6,000 because the company received $103,769, and they only have to pay back $100,000 **$3,769 (the total premium) /10 periods ***Amount of interest to be paid = 6% (.06) x $100,000

  48. Accounting for Bonds PayableGuidelines • Remember to use the correct present value table • Use present value of $1 for repayment of the face amount • Use present value of an annuity for the interest payments • If the bond pays interest semiannually, the number of periods to use on the table is 2 times the number of years to the bond’s maturity • When using the tables, always use the market rate • If the bond pays interest semiannually, the amount of interest to use in the tables is ½ of the market rate • To calculate the amount of the annuity (the interest payment), use ½ of the contract rate if the bond pays interest semiannually • This is the amount that will be multiplied by the factor from the present value of an annuity table.

  49. Zero-Coupon Bonds • Zero-coupon bonds do not have interest payments • The bonds are sold at a large discount • The accounting for zero-coupon bonds is similar to that for interest-bearing bonds that have been sold at a discount

  50. Bond Sinking Funds • The bond indenture (contract with the bondholders) may require that the corporation restrict dividend payments to stockholders to protect the bondholders • In addition, the bond indenture may require the corporation to set aside funds over the life of the bond issue • the amounts set aside are kept separate from other assets in a special fund called a sinking fund • when investments are purchased with the sinking fund cash, they are recorded in an account called Sinking Fund Investments • any income received (interest or dividends) is recorded in an account called Sinking Fund Revenue

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