Chapter 10 - Bonds

What

is a bond?

Bonds are securities issued by corporations and governmental units when they borrow large amounts of money Long-term Liability (unless currently maturing) Like stock securities, bonds are traded on established exchanges such as the New York Bond Exchange
Who

buys bond securities?

Advantages of raising long-term capital with bonds versus issuing common stock

Ownership and control of the company are not diluted Interest expense is tax deductible (dividends paid to stockholders are not) Organizations can borrow funds at a specified interest rate and then invest the funds at a higher rate (positive financial leverage) but this also increases financial risk

Bonds Payable
Face Value $1,000 Interest 10% 6/30 & 12/31

First State Bank

Bond Date 1/1/08 Maturity Date 12/31/17

1. 2. 3. 4. 5.

Face Value = Maturity or Par Value (Principal Amount) Maturity Date Other Factors: Stated Interest Rate 6. Market Interest Rate Interest Payment Dates 7. Issue Date Bond Date

Terminology

Principal Amount payable at the maturity of the bond Amount on which interest payments are computed Other terms for bond principal: Par Value Face Amount Maturity Value Stated Interest Rate Rate of interest specified on the bond contract Other terms for stated rate: Coupon rate Contract rate Nominal rate

Terminology
Market

interest rate (yield rate, effectiveinterest rate) Interest rate demanded by investors to induce them to invest in a particular bond Based on the riskiness of the bonds What does the bond sell for if: The market rate is the same as the coupon rate? The market rate is higher than the stated rate? The market rate is lower than the stated rate?

Bond Covenants

Callable bonds
May be retired and repaid (called) at any time at the option of the issuer.

Redeemable bonds
May be turned in at any time for repayment at the option of the bondholder.

Convertible bonds
May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder.

Bond Covenants

Collateral
Unsecured Debentures Secured or Collateralized

Repayment of principal
Ordinary or single payment Serial a series of maturity dates

Interest Payment procedure

Registered Coupon

Claim rank
Senior Subordinated

Cash outflows - What will be paid to Investors?

Stated

Principal (at maturity) Interest (at stated interest rate and payment
dates--quarterly, semi-annually, annually)
Interest paid to investors is at the STATED rate Stated principal and interest payments determine the timing and amounts of cash flows associated with a bond.
Issue Date

Maturity Date

Issue Price Received

Interest Paid

Interest Paid

Interest & Principal Paid

Issue Price What will be received from Investors?

Bonds will sell at the amount that equals the: Present Value of the Principal + Present Value of Interest payments Investors who buy bonds will require that they earn the current market rate of interest (the

yield or effective-interest). The market rate of interest is used to determine the present values mentioned above.

Issue Price of Bonds

PAR Stated interest rate = market rate Implies Bond issue price = par value of bond PREMIUM Stated interest rate > market rate Implies Bond issue price > par value of bond DISCOUNT Stated interest rate < market rate Implies Bond issue price < par value of bond

What does the seller record in the accounts?

Cash

is debited for the Issue Price which is the Present Value of the Future Cash Flows (principal and interest payments) using the MARKET rate of interest Bonds Payable is credited for the same amount NOTE: Class notes do not use Premium or Discount accounts. [The method in the notes is simpler and more modern than the method used in the text. Either is acceptable.]

Periodic interest payments

The stated rate, or coupon rate, is only used to compute the periodic interest payments.
These payments do not change over the term of the bond.

The market rate at issue (yield to maturity, effective interest rate) is used to compute interest expense. The difference between cash paid and interest expense is an increase or decrease in bonds payable.

Issuing Bonds (at par)

On January 1, Year 1, Harrah s issues $1,000,000 in bonds having a stated rate of 8% annually. The bonds mature in 10 years and interest is paid annually each December 31. The market rate is 8% annually. Compute the issue price of Harrah s bonds. First we will separately compute the value of the principal and the PV of the interest.

Issuing Bonds (at par)

1. Compute the present value of the principal using the market rate of interest.
FV = ($1,000,000), n = 10, i = 8%* PV = $463,193
*Market interest rate In table A-1 of the textbook, the present value of $1 to be received in 10 years and discounted at 8% = 1/(1.0810) = 0.4632. Bond tables are obsolete. No one uses them anymore. Present values are calculated in a computer or financial calculator.

Issuing Bonds (at par)

2. Compute the interest payments.
$1,000,000 8%* = $80,000
*stated interest rate

3. Compute the present value of the interest payments.

PMT = ($80,000), i = 8%**, n = 10, END PV = $536,807
**market interest rate

Issuing Bonds (at par)

4. Compute the issue price of the bonds. $ 463,193 Present value of principal repayment 536,807 Present value of interest payments $1,000,000 Present value of bonds (all cash flows)
Alternatively, compute the issue price directly: FV = ($1,000,000), PMT = ($80,000), i = 8%*, n = 10, END PV = $1,000,000

Issuing Bonds (for less than par)

On January 1, Year 1, Harrah s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid annually each December 31. The market rate is 8% annually.

Compute the issue price of Harrah s bonds.

Issuing Bonds (for less than par)

1. Compute the present value of the principal using the market rate of interest.
FV = ($1,000,000), n = 10, i = 8%, END PV = $463,193

Issuing Bonds (for less than par)

2. Compute the interest payments.
$1,000,000 6% = $60,000

3. Compute the present value of the interest payments.

PMT = ($60,000), i = 8%, n = 10, END PV = $402,605

Issuing Bonds (for less than par)

4. Compute the issue price of the bonds.
$463,193 Present value of principal 402,605 Present value of interest $865,798 Present value of bonds (all cash flows) Because $865,798 is less than the stated face of the bonds, these bonds are issued at a discount. Alternatively, compute the issue price directly:
FV = ($1,000,000), PMT = ($60,000), i = 8%, n = 10, END

PV = $865,798

Recording Bonds (issued at less than par)

Prepare the journal entry to record the issuance of the bonds. Jan. 1, Yr 1 Cash 865,798 Bonds payable 865,798
Textbook entry Cash 865,798 Discount on bonds payable 134,202 Bonds payable 1,000,000

Issuing Bonds (for more than par)

On January 1, Year 1, Harrahs issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is paid annually on 12/31. The market rate is 8% annually.

What is the issue price?

Issuing Bonds (for more than par)

Determine the amount and timing of cash flows Lump sum payment in 10 years = $1,000,000 Interest payment annually on 12/31 = $1,000,000 x stated interest rate = $1,000,000 x 10% = $100,000

Issuing Bonds (for more than par)

Determine the issue price of the bonds (the present value of the cash flows discounted at the market rate of interest) FV = ($1,000,000), PMT = ($100,000), i = 8%, n = 10, END PV = $1,134,202 issue price

Recording Bonds (issued at more than par)

Prepare the journal entry to record the issuance of the bonds. Jan. 1, Yr 1 Cash 1,134,202 Bonds payable 1,134,202 Because the issue price is greater than the stated face, these bonds are said to be issued at a premium.
Textbook: Cash 1,134,202 Premium on bonds payable 134,202 Bonds payable 1,000,000

Effective-Interest Method of Recognizing Interest Expense

The effective-interest method computes Interest Expense as: Bond Carrying Value Market Interest Rate (at the date of issuance)

Effective Interest Method

(bond issued at discount) On January 1, Year 1, Harrah s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid annually each December 31. The market rate is 8% annually. Jan. 1, Yr 1 Cash 865,798 Bonds payable 865,798

Interest Expense (bond issued at discount)

The annual interest payment is $1,000,000 x 6% = $60,000. Interest expense for Year 1 = Bond carrying value during 2002 x market rate of interest (when bonds were issued) = $865,798 x 8% = $69,264.

Interest Expense (bond issued at discount)

12/31/Yr 1 journal entry: Interest expense Cash Bond payable 69,264 60,000 9,264

The excess of the expense over the payment is added to the bond payable account, increasing the carrying value of the bonds for Year 2.

Interest Expense (bond issued at discount)

Bonds Payable 1/1/Yr1 12/31/Yr1 12/31/Yr1 balance 865,798 9,264 875,062

12/31/Yr 2 journal entry: Interest expense Cash Bond payable

70,005 60,000 10,005

In Yr 2, interest expense = $875,062 x 8% = $70,005

Interest Expense (bond issued at discount)

Bonds Payable 1/1/Yr1 12/31/Yr1 12/31/Yr2 865,798 9,264 10,005 12/31/Yr1 balance 875,062 12/31/Yr2 balance 885,067

In Yr 3, interest expense = $885,067 x 8% = $70,805

Amortization Table
Set up an amortization table for the bonds payable.

Effective-Interest Method Amortization Table

(a) Interest Payment (b) (c) Interest Change in Expense Carrying val. (d) Carrying Value

Date

Amortization Table
Set up an amortization table for the bonds payable.

$1,000,000 6% = $60,000 *credit Cash

Amortization Table

$865,798 8% = $69,264

*debit Interest expense

Amortization Table

$69,264 - $60,000 = $9,264 * Debit or credit Bonds payable for the difference in this case, credit bonds payable.

Amortization Table

$865,798 + $9,264 = $875,062

Bond Amortization Schedule

Debt-to-equity ratio
The debt-to-equity ratio is a measure of the balance between debt and equity.
Debt-to-equity ratio = Total liabilities Stockholders' equity

Larger debt-to-equity ratios indicate higher leverage and more risk. Netflix debt-to-equity = .78 (.58 in 2007) Blockbuster debt-to-equity = 9.05 (3.17 in 2007)

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Practice: Zero-Coupon Bonds

On January 1, Year 1, Ross Corporation issued zero-coupon bonds with a par value of $5,000,000. The bonds mature on 12/31/Year 10 (in 10 years). These bonds pay no interest annually (i.e., the stated rate is zero %). When the bonds are issued, the market rate of interest is 10%. Give the entries to record the issuance of the bonds and to recognize interest expense on 12/31/Yr 1 and 12/31/Yr 2.

Practice: Zero-Coupon Bonds

FV = ($5,000,000), PMT = 0, i = 10%, n = 10 PV = $1,927,716 1/1/Yr 1 Cash 1,927,716 Bonds payable 1,927,716
1,927,716 3,072,284 5,000,000

Textbook: Cash Discount on Bonds Payable Bonds Payable

Practice: Zero-Coupon Bonds

Year 1 Interest expense = $1,927,716 x 10% = $192,772 12/31/Yr 1 Interest expense 192,772 Bonds payable 192,772

Practice: Zero-Coupon Bonds

Bonds Payable 1/1/Yr 12/31/Yr1 1,927,716 192,772 12/31/Yr1 balance 2,120,488

Practice: Zero Coupon Bonds

In Yr 2, interest expense = $2,120,488 10% = $212,049

12/31/Yr 2 journal entry: Interest expense 212,049 Bonds payable 212,049 Textbook: Interest expense 212,049 Discount on bonds payable 212,049

Practice: Zero-Coupon Bonds

At what values are Bonds Payable reported on the balance sheet at 12/31/Yr 1? 12/31/Yr 2?
Bonds Payable 1/1/Yr 12/31/Yr1 12/31/Yr2 1,927,716 192,772 212,049

12/31/Yr1 balance 2,120,488 12/31/Yr/2 balance 2,332,537

FV=5,000,000, i=10%, n=9, END PV = $2,120,488 FV=5,000,000, i=10%, n=8, END PV = $2,332,537

Practice: Zero-Coupon Bonds

Suppose Ross retires the bonds on 1/1/Year 6 when the market interest rate is 11%. Give the journal entry to recognize the retirement.
Book value (PV of remaining cash flows at 10%): FV=5,000,000, PMT=0, i=10%, n=5, END PV = $3,104,607 Market value (PV of remaining cash flows at 11%): FV=5,000,000, PMT=0, i=11%, n=5, END PV = $2,967,257 1/1/Yr6: Bonds payable 3,104,607 Cash Gain on retirement 2,967,257 137,350