AC 311 Test 1 - Bonds Chapter 14
Steps for making an amortization schedule for bonds sold at a premium
1. 5 columns: Date, Cash Interest, Effective Interest, Decrease in Balance (Premium reduction), Outstanding Balance 2. On date of issue, row is blank except for outstanding balance which is the present value of the bonds cash flows 3. for every date, cash interest is (bond rate/2 * Face amount) 4. Effective interest is (market rate * outstanding balance of prev year) 5. Decrease in balance is the difference between effective and cash interest (gets larger as you move forward in time) 6. Outstanding balance is prev time period OB plus the decrease in balance
What are the steps to preparing an amortization schedule for a bond sold at a discount
1. 5 columns: Date, Cash Interest, Effective Interest, Increase in Balance (Decrease in discount), Outstanding Balance 2. On date of issue, row is blank except for outstanding balance which is the present value of the bonds cash flows 3. for every date, cash interest is (bond rate * Face amount) 4. Effective interest is (market rate * outstanding balance of prev year) 5. Increase in balance is the difference between effective and cash interest 6. Outstanding balance is prev time period OB plus the increase in balance
What is the amortization schedule for a zero coupon bond
1. Cash interest is always zero 2. Outstanding balance in the first period is whatever amount the whole group of bonds sold for 3. Effective interest = yield rate * previous year OB 4. Increase in balance = effective interest amount 5. OB= previous year OB + Increase in balance
maturities for bonds range from
10-40 years
Company called its 700 000, 12% bonds when their book value was 676 288. The indenture specified a call price of 685 000. The bonds were issued previously at a price to yield 14%. Record the journal entries to record this early extinguishment
Debit bonds payable 700 000 Debit loss on early extinguishment ( 685 000 - 676 288) 8712 Credit discount on bonds payable (700 000 - 676 288) 23 712 Credit cash (call price) 685 000
If one half of the warrants (1 million) are exercised when the market value of the company's common stock is 30 per share, 1 million shares would be issued for one warrant each plus the exercise price of 25 per share
Debit cash (1 million warrants x $25) 25 Debit equity - stock warrants (1 million x $3) 3 Credit common stock (to balance) 28
If a company issues 700 000 of 12% bonds on Jan 1, and there is interest of 42 000 paid semiannually on June 30 and Dec 31, and the bonds mature in 3 years, and the entire bond issue was sold at the face amount, and United Intergroup, Inc. planned to hold the bonds to maturity, what is the journal entry for the issuer on Jan 1
Debit cash 700 000 Credit bonds payable (Face amount) 700 000
When bonds with warrants are issued and both the stock and warrant market values are known,
Debit cash by the % of par given. Find the market values of both entities. Sum these together then find the percentage that both make up of that total sum. Multiply this percentage by the cash amount. Credit BP and APIC warrants by these amounts. Remember to debit or credit discount or premium depending on if the BP part is above or below 1000 If only given SW market value, then find the difference and that is the BP amount. if only given BP amount, then find the difference and that is the SW amount.
What is the journal entry for the investor
Debit investment in bonds 700 000 (face amount) Credit cash 700 000
Increase in balance in an amort schedule for a discount bond=
Difference between effective and cash interest
journal entry for 30% conversion
Dr BP (FV * % of shares converted) Dr Prem/Cr Disc (% of shares converted * the amount given - must be calculated separately from BP) Cr CS (Par x shares converted x shares per bond) Cr APIC difference
journal entry for 100% conversion
Dr BP FV Dr Prem/Cr Disc (this will be given) Cr CS (par value x number of bonds x shares per bond) *do not use a stock price here* Cr APIC (difference)
On Jan 1: Outstanding balance: 666 633 Bonds Payable face amount: 700 000 Discount on bonds payable: 33 367 What is the interest accrued vs. Portion of interest paid?
Interest accrued at 7%: Outstanding balance: 46 664 Interest paid: Outstanding balance: (42 000) Discount on bonds payable: (4 664)
For convertible bonds, what are the steps
Issuance: Debit cash by the % of par given. Cr BP, net by an equivalent amt Conversion: Debit BP by the fraction of bonds converted + the unamortized discount or premium Credit common stock by multiplying par value * number of bonds converted * number of shares acquired per bond. APIC is the difference
Effective interest in an Amort Schedule for a discount bond always =
Market rate / 2 * Face Amount
If financial statements end on October 31 and interest was last paid and recorded on June 30, four months' interest must be accrued in a year-end adjusting entry. This would be done by
Take the numbers from the amortization schedule and multiply them by 2/3 Debit interest expense Credit discount on bonds payable Credit interest payable Do the same things for November and December in the next fiscal year, except (1/3)
For issuance of convertible bonds, do not use
a market value that is given for the bonds
zero coupon bonds offer
a return in the form of a "deep discount" from the face amount
obligate the issuing corporation to repay a stated amount (referred to as principal, par value, face amount, maturity value) at the maturity date
bond
document containing the specific promises made to bondholders
bond indenture
The cash interest of a bond sold at a premium is
bond rate/2
No call provisions usually prohibit
calls during the first few years of a bond's life
advantage of zero-coupon bond to a corporation
can deduct for tax purposes the annual interest expense but has no related cash outflow until the bonds mature.
why are bonds useful
can get funding for debt from thousands of lenders of a smaller sum of money rather than borrowing 100s of millions from one bank
when issuing bonds or notes, the issuing company will incur costs which are recorded by
combining them with any discount (or subtracting them from any premium) on the debt. The combined valuation account is on the balance sheet as a direct deduction from the liability and then amortized over the life of the debt
When additional consideration is provided o induce conversion, the fair value of that consideration is
considered an expense incurred to bring about the conversion
retired as a consequence of bondholders choosing to convert them into shares of stock
convertible stock
Bond issuers agree to pay interest to bondholders between issue date and maturity. The periodic interest is stated as a % of the face amount (referred to as __________ )
coupon rate
what are the JEs for when half the convertible bonds are converted when the remaining unamortized premium is 2 million
debit bonds payable (1/2 the account balance) 50 Debit premium on bonds payable (1/2 the account balance) 1 Credit common stock (to balance) 51
what are the journal entries for early extinguishment
debit bonds payable (face amount) credit discount on bonds payable (face amount - outstanding balance) Credit cash (call price) Use a plug to either debit loss on early extinguishment for (call price - outstanding balance) or credit gain on early extinguishment for (outstanding balance - call price)
when bonds with warrants are issued, what are the journal entries
debit cash (% of par given) Cr BP w/o warrants (either MV of bonds, or a plug) Cr APIC SW (either MV of warrants or a plug) Discount or premium depending on whether BP w/o warrants is above or below 100
Journal entry for convertible bonds
debit cash (% of par given) credit bonds payable (Face value) debit or credit discount/premium as needed
a company issues 100 million of 8% convertible bonds due 2041 at 103 (103% of face value). The bonds are convertible at the option of the holder into no par common stock at a conversion rate of 40 shares per $1000 bond. Company recently issued nonconvertible 20-year, 8% debentures at 98 what are the JEs at issuance
debit cash (103% x 100 million) 103 Credit convertible bonds payable (face amount) 100 Credit premium on bonds payable 3 All subsequent entries, including the periodic premium reduction are the same as non-convertible bonds
a company issues 100 million of 8% debentures due 2025 at 103. Accompanying each 1000 bond were 20 warrants. Each warrant permitted the holder to buy one share of no par common stock at 25 per share. Shortly after issuance, the warrants were listed on the stock exchange at 3 per warrant
debit cash (103% x 100 million) 103 debit discount on bonds payable (difference) 3 Credit bonds payable (face amount) 100 Credit equity - stock warrants (100 000 x 20 warrants x $3) 6
when the warrants are exercised, what are the JE
debit cash (pre determined price per share * number of warrants) debit SW-APIC (% of total warrants exercised * current balance in this account) Credit CS (par value * number of warrants) Credit APIC - excess (difference)
a company issues 100 million of 8% debentures due 2025 at 103. Accompanying each 1000 bond were 20 warrants. Each warrant permitted the holder to buy one share of no par common stock at 25 per share. Shortly after issuance, the warrants were listed on the stock exchange at 3 per warrant
debit cash 103 debit discount on BP 3 credit bonds payable 100 credit warrants 6
If the present value of bonds is 666, 633, and there are debt issue costs of 14000, what are the journal entries
debit cash 652 633 (666 633 - 14 000) Debit discount and debt issue costs (difference) 47 367 Credit bonds payable (face amount) 700 000
What are the journal entries to record cash flows from a bond issue at a discount for an ISSUER
debit cash 666 633 debit discount on bonds payable 33 367 credit bonds payable (face amt) 700 00
Journal entries for bonds sold at a premium for the issuer
debit cash 735 533 credit bonds payable 700 000 Credit premium on bonds payable 35 533
What are the journal entries for the issuer of a bond at June 30
debit interest expense 46 664 credit discount on bonds payable (difference) 4664 Credit cash (stated rate x face amount) 42 000
What are the journal entries to record cash flows from a bond issue at a discount for an INVESTOR
debit investment in bonds (face amount) 700 000 credit discount on investment in bonds 33 367 credit cash 666 633
A call feature protects a bond issuer from
declining interest rates
when debt is retired prior to its scheduled maturity date, the transaction is referred to as
early extinguishment of debt
The reason that the premium gets amortized over time for a bond sold at a premium is that the
effective interest each period is less than the cash interest paid
recording interest each period as the effective market rate of interest multiplied by the outstanding balance of the debt
effective interest method
periodic interest is the
effective interest rate times the amount of the debt outstanding during the period
The total interest paid is the cash interest paid during the term to maturity plus the
extra amount paid at maturity (the extra is the 700 000 paid at maturity - 666 633 PV that is borrowed; this is due to the higher than market interest rate)
The debt (OB) declines each period in a bond sold at a premium. This is because as the premium is reduced by amortization, the book value of the bonds declines toward
face value
The hybrid nature of a convertible bond gives
fixed-income security that can become common stock if and when the firm is prosperous (increases upside, limits risk)
A liability requires the
future payment of cash in specified amounts, at specified dates. As time passes, interest accrues on debt
a detachable stock purchase warrant is a way to sweeten a bond issue. It involves
giving the investor an option to purchase a stated number of shares of common stock at a specified option price. (allow company to lower interest rate and enable a company to issue debt when borrowing is not feasible)
If 12% bonds are competing in a market in which similar bonds are providing a 10% return, the bonds could be sold at a price
greater than 700 000
another option is for a bond to be secured by non-real estate assets in which case, if the issuer does not pay the holder back, the holder
has rights to take assets belonging to the issuer such as property, plant, equipment
the people who invest in zero-coupon bonds usually
have tax deferred or tax exempt status such as pension funds, IRAs and charitable org.
When warrants are exercised, do not
include the unamortized discount in the journal entry
For a bond sold at a discount, the outstanding balance _____ each period
increases
The outstanding balance is 666 633, and the effective rate is (14% / 2) = 46, 664. However, the bond indenture states there are semiannual interest payments of 42 000 (the stated 6% rate * 700 000). The difference is 4,664, and this
increases the liability and is reflected as a reduction in the discount (contra-liability account)
For a bond sold at a discount, the effective interest each period is more than the cash paid, so as the discount is reduced by amortization, the book value of the bonds
increases toward face value
Most bonds today are registered meaning that
interest checks are mailed directly to the owner of the bond, whose name is registered with the issuing company
Use one-half the stated rate of the bond (bc of semi annual interest payments) to calculate
interest payment amount
On August 1, 2021, Limbaugh Communications issued $25 million of 10% nonconvertible bonds at 104. The bonds are due on July 31, 2041. Each $1,000 bond was issued with 30 detachable stock warrants, each of which entitled the bondholder to purchase, for $60, one share of Limbaugh Communications' no par common stock. Interstate Containers purchased 20% of the bond issue. On August 1, 2021, the market value of the common stock was $58 per share and the market value of each warrant was $8.In February 2032, when Limbaugh's common stock had a market price of $73 per share and the unamortized discount balance was $2 million, Interstate Containers exercised the warrants it held. What are the JES for issuance of the bonds and the exercise of the warrants
issuance: debit cash 26 debit discount on BP 5 Credit BP 25 Credit equity - stock warrants 6 (market price of warrants * warrants per share * # of shares) Exercise of warrants: debit cash 9 (20% x 25000 bonds x 30 warrants x $60) Debit equity - stock warrants 1.2 (6 million x 20%) Credit common stock 10.2
If 12% bonds are competing in a market in which similar bonds are providing a 14% return, the bonds could be sold at a price
less than 700 000
a bond selling at a discount would sell for
less than face amount
because a mortgage bond is considered less risky than debentures, it will have a
lower interest rate
The effective interest of a bond sold at a premium is
market rate * outstanding balance
a bond selling at a premium would sell for
more than face amount
a bond that is backed by a lien on specified real estate owned by the issuer
mortgage bond
When warrants are exercised, first step is to
multiply the pre determined stock price by the number of warrants being exercised. Then, debit warrants - APIC account by the fraction of total warrants being exercised. Then, use this to find common stock and APIC excess
If 700 000 of 12% bonds are sold when the market rate is 10%, there is interest of 42 000 paid semiannually on June 30 and December 31. The bonds mature in three years. The purchaser of the entire bond issue is going to hold the bonds until maturity. How would you calculate the present value of the bonds
n=6 (3 years * 2 interest payments a year) i=5% (half market rate) PMT = 42 000 (700k * 6%) FV = 700 000 CMT PV
zero coupon bonds pay
no interest
Investors receive _______ for zero coupon bonds
no periodic cash interest, even though annual interest revenue is reportable for taxes
Warrants are sold with bonds as a
package for a single issue price (can be exercised independently or traded in the market separate from the bonds)
The call price must be
pre-specified and often exceeds the bond's face amount (a call premium), declining as maturity is approached
The decrease in balance of a bond sold at a premium is
premium reduction. It is the difference between the cash interest and effective interest and it increases as the time periods pass
Forces of supply and demand cause a bond issue to be priced to yield the market rate. This means that the price of a bond will be the
present value of the periodic cash interest payments (face amount * stated rate) plus the present value of the principle payable at maturity, both discounted at the market rate
Outstanding balance for a discount bond =
previous period OB + this period increase in balance
when a company sells debt securities directly to a single investor (ie pension fund or insurance company)
private placement
Interest is paid
semiannually on designated interest dates beginning 6 months after the day the bonds are dated
provide a more structured way to retire bonds on a piecemeal basis. Retired in installments during all or part of the life of the issue. Each bond has its own specified maturity date, so there are 25-30 separate maturity dates assigned to specific portions of a bond issue for a 30-year serial issue
serial bonds
convertible bonds can be converted into
shares of stock at the option of the bondholder
The corporation may be required to redeem the bonds on a prespecified, year-by-year basis, known as
sinking fund redemptions (very popular)
Companies usually set prices so that there is a
slight discount rather than a slight premium
bond which is not entitled to receive any liquidation payments until the claims of other specified debt issues are satisifed
subordinated debenture
The bond indenture is usually held by a trustee (bank or other financial institution) appointed by the firm to represent rights of the bondholders. If the company fails to pay back the bonds, the trustee may
sue the company on behalf of the shareholders
Use one-half the stated market rate (bc of semi-annual interest) for
the I/Y input in the calculator when calculating the present value of the bond
Two different securities, bonds and warrants, are sold as a package for a single issue price. The price is allocated between the two securities on the basis of their fair values. So, if only one of the two securities is reliably determinable, this value establishes
the allocation
when a bond is called, you multiply the call percentage (around 100) times
the current face value not including discount or premium
When bonds with warrants are issued and you are given the market value of either SW or BP but not both, then the other is
the difference between the one you know and cash received
The total interest paid is the cash interest paid during the term to maturity plus
the extra amount paid at maturity.
Most corporate bonds are callable, meaning
the issuing company can buy back, or call outstanding bonds from bondholders before they reach maturity.
long-term liabilities are reported at their present values. Present value of a liability is defined as
the present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest
The outstanding balance for a discount bond is the
the present value of the remaining cash flows, discounted at the original rate. The outstanding amount of the debt is its book value, which is the face amount minus the balance in the discount
A bond can sell at a premium or discount depending on how
the stated interest rate compares with the prevailing market or effective rate of interest (for securities of similar risk and maturity)
total interest expense (from the issuer perspective) for a discount bond is equal to
the sum of the total cash interest plus the total change in the balance (the discount)
Most corporate bonds are debenture bonds, meaning
they are backed solely by the full faith and credit of the issuing corporation. Has the same status as the firm's other general creditors, so in case of bankruptcy the debenture holder does not have priority over other debtors
reasons for issuing convertible bonds rather than straight debt
to sell the bonds at a higher price (lower effective interest) to use a medium of exchange in mergers and acquisitions To enable smaller firms or debt-heavy companies to obtain access to the bond market an indirect way to issue stock when there is shareholder resistance to direct issuance of additional equity
When an investment banker purchases an offering from a bond issuer and then resells it to the public, this is known as a
underwriter (the underwriting fee is the spread between the price the underwriter pays and the resale price
zero coupon bonds show that
we accrue interest expense or revenue regardless of how much cash interest is actually paid
How does the call provision work
when the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bond holders with incentive to convert
The stated interest rate on a bond is still referred to as a coupon rate because
years ago it was typical for bonds to be structured as coupon bonds in which the owner of the coupon was not registered and he had to get an attached coupon clipped in order to redeem his interest
Cash Interest in an Amort Schedule for a discount bond always =
Bond rate / 2 * Face Amount
Why is induced conversion necessary
Because the market price of the convertible bonds will rise along with the market prices of the stock. Companies want to reduce debt and become a better risk to potential lenders or achieve a lower debt[to-equity ratio
bonds priced at 98 means a $1000 bond will sell for
980
amortization schedule
A schedule that details each loan payment's allocation between principal and interest and the beginning and ending loan balances.
Why is the callable feature helpful
Allows a company protection against high-cost debt in the event that interest rates fall during the period before maturity
a company issues 100 million of 8% debentures due 2025 at 103. The bonds have a separate market price of 940 (priced at 94) without the warrants, and accompanying each 1000 bond were 20 warrants. Each warrant permitted the holder to buy one share of no par common stock at 25 per share. Shortly after issuance, the warrants were listed on the stock exchange at 3 per warrant
Market value of bonds: (100 000 bonds x 940 = 94 mill (94%) Market value of warrants: (100 000 bonds x 20 warrants x $3) = 6 million (6%) Proportion of Issue Price allocated to bonds: 103 million * 94% = 96 820 000 Proportion of Issue Price allocated to warrants: 103 million * 6% = 6 180 000 Debit cash (103% x 100 million) 103 mill Debit discount on BP (100 mill - 96.82 mill) 3.18 Credit BP 100 mill credit Equity - stock warrants (103 million x 6%) 6.18 mill
Calculating the price of bonds sold at a discount: Masterwear issued 700 000 of 12% bonds on Jan 1. Interest of 42 000 is due semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. Another company purchased the entire bond issue and plans to hold until maturity. How do you calculate the price of this bond sold at a discount?
N=6 (3 years with 2 interest payments per year) I/Y=7 PMT= -42 000 FV = -700 000 CPT PV PV = 666 633
On June 30: Outstanding Balance: Bonds Payable: Discount on bonds payable:
OB: 666 633 + 46 644 (accrued) - 42 000 (interest paid) = 671 297 on June 30 BP = 700 000 on Jan 1 and June 30 Discount on BP: 33 367 - 4 664 = 28 703 on June 30
