Reporting and Interpreting Bonds

1. Reporting and Interpreting Bonds Chapter 10

2. 1,000 $10,000, 9% bond due 2019 Interest for Investor Borrower Bonds • Long-term borrowing arrangement • Interest paid at stated rate and times • Amount repaid at maturity date Investor Borrower LO2

3. Insurance Companies Pension Plans Banks Long-Term Notes Payable and Bonds Relatively small debt needs can be filled from single sources.

4. Long-Term Notes Payable and Bonds Significant debt needs are often filled by issuing bonds to the public. Bonds Cash

5. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Bond Features Serial Face value repaid in installments over time Term Face value repaid in lump sum on a specific single date

6. Common Stock 1,000 Bond Features Convertibleinto common stock Callable (by issuer) or Redeemable (by investor)– may be retired before maturity date

7. Bonds Sold at Face Value Cash 10,000 Bonds Payable 10,000 To record the issuance of bonds at face value. In this an atypical situation Face value of bonds = Sales price

8. Bond Interest Rates Face rate Rate specified on the bond certificate Market rate Rate investors could obtain by investing in other bonds similar to the issuing firm’s bonds LO3

9. Face Interest RateSynonyms • Coupon rate • Nominal rate • Stated rate • Face rate • Contract rate LO3

10. Market Interest RateSynonyms • Yield or bond yield or yield to maturity • Effective rate • Market rate • Actual rate • Real rate LO3

11. Calculating Bond Prices Two sets of cash flows (1) Interest payments made each period PVOA = ? etc. $$ $$ $$ $$ (2) Principal due at maturity PV = ? $$$$$

12. Determining Bond Prices Example, p. 474 On 1/1/07, Discount Firm issues • $10,000, 8% bonds • Due December 31, 2010 • Interest payable annually • Market rate of interest = 10% Calculate the issue price of the bonds.

13. 2008 2009 2010 2007 Calculating Bond Prices (1) Interest payments (4 payments @ $800) PVOA = ? $800 $800 $800 $800 Interest always paid at face rate ($10,000 @ 8%)

14. 2008 2009 2010 2007 Two sets of cash flows Calculating Bond Prices (1) Interest payments (4 payments @ $800) PVOA = ? $800 $800 $800 $800 (2) Principal of $10,000 due at end of 2010 2010 $10,000 PV = ?

15. Compute interest payment at face rate (i.e., 8%) ... … but discount @ market rate Example of Price Calculation • Present values • Interest payments • $800 × 3.170 = $2,536 • (PVOA; n = 4; i = 10%) • Principal payment • $10,000 × 0.683 = 6,830 • (PV; n = 4; i= 10%) • Bond issue price $9,366

16. Recording Bond Discounts Cash 9,366 Discount on Bonds Payable 634 Bonds Payable 10,000 To record the issuance of bonds payable. Assets = Liabilities + Owners’ Equity +9,366 –634 +10,000 LO4

17. Balance Sheet Presentation of Bond Discount Long-term liabilities Bonds payable $10,000 Less, Discount on bonds payable 634 $ 9,366

18. Determining Bond Prices Assume Premium Firm sells the same $10,000, 8% bonds when the market rate on similar bonds is 6%.

19. Compute interest payment at stated rate (i.e., 8%) ... … but discount @ market rate Example of Price Calculation • Present values • Interest payments • $800 × 3.465 = $ 2,772 • (PVOA; n = 4; i= 6%) • Principal payment • $10,000 × 0.792 = 7,920 • (PV; n = 4; i= 6%) • Bond issue price $10,692

20. Recording Bond Premiums Cash 10,692 Bonds Payable 10,000 Premium on Bonds Payable 692 To record the issuance of bonds payable. Assets = Liabilities + Owners’ Equity +10,692 +10,000 +692

21. Balance Sheet Presentation of Bond Premium Long-term liabilities Bonds payable $10,000 Plus, Premium on bonds payable 692 $10,692

22. Interest Rates and Bond Prices IF STATED RATEBONDS ISSUED Above face value at a premium At face value Below face value at a discount > MARKET RATE = MARKET RATE < MARKET RATE

23. Amortization of Bond Premiums and Discounts Periodically transfer a portion of discount or premium from respective account to interest expense over the life of the bond using the effective interest method Premium reduces interest expense Discount increases interest expense LO5

24. Reporting Interest Expense: Effective-Interest Amortization • The effective interest method is the preferred method. • Compute interest expense by multiplying the carrying value as of the beginning of the period times the market rate of interest. • The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest.

25. Amortization Schedule – DiscountFace rate = 8% Market rate = 10% Cash Interest Discount Carrying Date Interest Expense Amortized Value 1/1/07 — — — $ 9,366 12/31/07 $800 $937 $137 9,503 12/31/08 800 950 150 9,653 12/31/09 800 965 165 9,818 12/31/10 800 982 182 $10,000

26. Amortization Schedule – PremiumFace rate = 8% Market rate = 6% Cash Interest PremiumCarrying Date Interest Expense Amortized Value 1/1/07 — — — $10,692 12/31/07 $800 $642 $158 10,534 12/31/08 800 632 168 10,366 12/31/09 800 622 178 10,188 12/31/10 800 612 188 $10,000

27. XYZ Corporation issues $500,000, 8%, 5 year bonds on January 1, 2010. The bonds pay interest semi-annually on June 30 and December 31. The effective rate of interest on the issue date is 10%. XYZ’s year end is December 31.

28. Compute interest payment at face rate (i.e., 8%) ... … but discount @ market rate Example of Price Calculation • Present values • Interest payments • $20,000 × 7.7217 = $154,434 • (PVOA; n = 10; i = 5%) • Principal payment • $500,000 × 0.6139 = 306,950 • (PV; n = 10; i = 5%) • Bond issue price $461,384

29. Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed as compared to owners?

30. Total Liabilities Debt-to-Equity = Stockholders’ Equity Debt-to-Equity This ratio shows the relationship between (1) the amount of capital provided by owners and (2) the amount provided by creditors. Generally, a high ratio suggests a company relies heavily on funds provided by creditors.

31. 1,000