Chapter 10

Bonds

A bond makes 2 promises: 1. Repayment of principle at maturity (face value of bond) 2. Periodic interest payments (semi-annual or annual)

Current Liabilities

Debt that a company expected to pay within one year or operating cycle. Accounts Payable Notes Payable Sales Taxes Payable Unearned Revenue Current Maturities of Long-Term Debt

Sales Taxes Payable

EXAMPLE: Buymore sells a laptop for 1000. Sales tax rat is 8.25% Cash 1082.50 Revenue 1000 Sales Tax Payable 82.50 Sales Tax Payable 82.50 Cash 82.50

Disadvantages of Issuing Bonds

The issuing firm must have sufficient cash to repay the principal and make interest payments

Summary of Bonds

When market rate= coupon rate- selling price = face value (issuing bonds at face value) When market rate> coupon rate- selling price < face value (issuing bonds at discount) When market rate< coupon rate- selling price > face value (issuing bonds at premium)

Notes Payable (short term)

Written notes; interest bearing: principal and interest due at maturity EXAMPLE: On May 1, ABC borrowed $60,000 on a 6 month, 10% note. To record issuance 5/1 Cash 60,000 Notes Payable 60,000 To record payment at maturity 11/1 Notes Payable 60,000 Interest exp 3,000 Cash 63,000

EXAMPLE: FV of bonds = 100,000 3-yrs, 10% semi-annual interest. Effective Yield = 12%, Determine the selling price of the bond.

i= 12% *6/12= 6% n= 3*2= 6 PV of Face Amount 100,000 *.70496= 70,496 PV of Interest Payments 100,000*10%*6/12= 5000 5000* 4.91732= 24,585 Selling price = 70,496+24,585= 95,085<100,000 Cash 95,085 Discount on B/P 4,915 Bonds Payable 100,000 B/S Long-term debt bonds payable 100,000 Less discount on B/P (4,915) ___________________________ Carrying value 95,085

EXAMPLE: Face value of bonds=100,000 3yr; coupon rate = 10% semi-annual interest; Market rate =8%. Determine selling price of bond

i= 8%*6/12= 4% n= 3*2= 6 PV of face amount 100,000*.790= 79,000 PV of interest payments 5000*5.242= 26,210 Selling price= 105,210>100,000 Cash 105,210 Bonds payable 100,000 Premium on B/p 5,210 B/S Bonds Payable 100,000 Add: premium on B/P 5,210 ______________________ Carrying value 105,210

EXAMPLE: Denver CO issues a 10%, 3 year bond, FV=100,000; interest is paid semi-annually; market rate of interest=10%. Determine the selling price of the bond.

i=10% *6/12= 5% n=3*2= 6 Interests payment every period= 100,000*10%*6/12= 5000 PV of face value 100,000* .74622= 74,622 PV of interests 5000* 5.07569= 25,378.45 Selling price = PV of interest + PV of face value = 100,000 Cash 100,000 Bonds Payable 100,000 Interest exp 5000 Bonds Pay 100,000 Cash 105,000

Determining the Market Value of a Bond

- Selling price of a bond is the present value of all future cash flows related to the bond on the issuance day - Because a bond is made up of two promises of future cash flows (principal and interest payments), you must find the present value of both to determine selling price Selling Price= PV of Face Value + PV of Interest Payments - Selling price of bonds is affected by both coupon rate and market rate: Market rate is the discount rate used in calculating the PV of bond. Coupon Rate is used to compute the cash payments for interest.

Effect of discount

1. Adds to the cost of borrowing (received less today, but must pay back face value at maturity) 2. Amortization of discount INCREASES interest expense because interest expense is calculated based on carrying value and true cost of borrowing. 3. Carrying value increases over life of bond until it reaches its face value at maturity

Advantages of Issuing Bonds

1. Interest expense is tax deductible; dividend is not tax deductible 2. Debt does not dilute ownership

Redeeming bonds before maturity

1. eliminate the carrying value of the bonds at the redemption date 2. record the cash paid 3. recognize the gain or loss on redemption (loss) xxx Bonds payable xxx Discount xxx Cash xxx (gain) xxx

Bonds Terminology

Face value (or par value)- the principle amount of the bond as stated on the bond certificate. Maturity date- the date that the final payment is due to the investor from the issuing company Contractual interest rate (or coupon rate or stated interest rate)- fixed rate of interest paid on face value of bond; used to determine the amount of cash interest Market rate (or effective rate or discount rate)- going rate of interest that borrowers and lenders are willing to accept

Determining Interest Expense using Effective Interest Method (DISCOUNT)

Rules: 1. Your true cost of borrowing is the market rate Use market rate to find interest expense 2. Use coupon rate to find cash payment only 3. Periodic interest expense= Mkt. Rate*Carrying value of bond