Chap 010

Chapter 10

Reporting and Interpreting Bonds

© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

10-2

Understanding the Business

The mixture of debt and equity used to finance a company’s operations is

called the capital structure:

Debt - funds from creditors

Equity - funds from owners


10-3

Significant debt needs of a company are often filled

by issuing bonds.

Understanding the Business:Capital Structure - Bonds

Bonds Cash


10-4

Bonds

A bond is a DEBT SECURITY that corporations, credit institutions or governmental bodies issue when they borrow large amounts of money.

It is a formal contract to repay borrowed money with interest at fixed intervals.

Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.


10-5

Pro and cons of bonds

Advantages of bonds:

Bonds are debt, not equity, so the ownership and control of the company are not diluted.

Interest expense is tax-deductible.

Disadvantages of bonds: Risk of bankruptcy; the

debt must be paid back regularly, or creditors will force legal action.

Negative impact on cash flows.


10-6

Characteristics of Bonds

$ Bond Issue Price $

Bond Certificate

At Bond Issuance Date

Bonds are long-term debt for the issuing company.

Company Issuing Bonds

Investor Buying Bonds


10-7


PeriodicInterest Payments

(coupon)$ $

Face (par) Value Payment at End of

Bond Term$ $

Company Issuing Bonds

Investor Buying Bonds


10-8

Bond indenture is a bond contract that specifies the legal provisions of bonds (maturity date, interest rate, date of interest payments, conversion privileges..)

It can also contain covenants to protect creditors

Bond Indenture


10-9

1. Face Value = Maturity or Par Value, Principal2. Maturity Date3. Stated Interest Rate 4. Interest Payment Dates5. Bond Date

Bond Indenture

Other Factors:6. Market Interest Rate7. Issue Date

BOND

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

Maturity Date 1/1/10Bond Date 1/1/01


10-10


When issuing bonds, potential buyers of the bonds are given a prospectus.

The company’s bonds are issued to investors through an underwriter (buys an entire issue of bonds and re-sells them to investors).

The trustee makes sure the issuer fulfills all of the provisions of the bond indenture.


10-11

Bond Classifications Secured bondsSecured bonds

Secured with the pledge of a specific asset. Debenture bondsDebenture bonds

Not secured with the pledge of a specific asset. Callable bondsCallable bonds

May be retired and repaid (called) at any time prior to the maturity date at the option of the issuer.

It happens when the issuer is paying a too high coupon rate than the current market interest

They may be reissued at a lower interest Called protection covenant: states the period in

which the bond cannot be called


10-12

Bond Classifications Term bondsTerm bonds

The principal is payable in full at a single specific date in the future

Serial bondsSerial bonds The principal is payable in installments on a series

of specific maturity dates Convertible bondsConvertible bonds

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


10-13

Key Ratio Analysis

The debt-equity ratio is an important measure of the balance between debt

and equity.

High debt-equity ratios indicate more leverage and risk.


10-14Measuring Bonds Payable and Interest Expense The stated ratestated rate is only used to compute

the periodic interest payments.


10-15

Issue price of a bond

The issue price of the bond is determined by the market, based on the time value of

money.

The interest rate used to compute the present value is the market interest rate market interest rate

(yield)(yield).


10-16

Issue price of a bond

The present value of a bond may be: the same as parabove the par (BOND PREMIUM)below the par (BOND DISCOUNT)

The bond sells at par Stated rate=market rateThe bond sells at

premiumStated rate>market rate

The bond sells at discount Market rate>stated rate


10-17

Bond Premium and Discounts

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10-18

Computing Bond Prices

On January 1, 2003, Harrah’s issues $100,000 in bonds having a stated rate of

10% annually. The bonds mature in 10 years and interest is paid semiannually.

The market rate is 12% annually.

Are Harrah’s bonds issued at par, at a discount, or at a

premium?


10-19





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10-20





Compute the issue price of Harrah’s bonds.


10-21


1. Compute the present value of the principal.


10-22


Use the market rate of 12% to determine present value. Interest is paid semiannually, so the rate is

r = 6% (12% ÷ 2 interest periods per year).


PV=100,000/(1+0.06)20=31,180

Though the maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use

n=20 (10 years × 2 periods per year).


10-23


2. Compute the present value of interest payments

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10-24



The semi-annual interest payment is The semi-annual interest payment is computed as:computed as:

$100,000 × 10% × 6/12$100,000 × 10% × 6/12

= $5,000= $5,000


10-25



$350,57)06.01(06.0

106.01000,5 20

PV

Use the same r = 6.0% and n=20 used for the present value of the principal.


10-26


31,180$ Present Value of the Principal + 57,350 Present Value of the Interest = 88,530$ Present Value of the Bonds

3.3. Compute the issue price of the bonds.Compute the issue price of the bonds.


10-27

31,180$ Present Value of the Principal + 57,350 Present Value of the Interest = 88,530$ Present Value of the Bonds


The $88,530 is less than the face amount of

$100,000, so the bonds are issued at a discount of

$11,470.

3.3. Compute the issue price of the bonds.Compute the issue price of the bonds.

BONDS are sold at 88.5% of their par value!!


10-28Recording BondsIssued at a Discount

This is a contra-liability account and appears in the liability section of the balance sheet.

4.4. Prepare the journal entry to record the Prepare the journal entry to record the issuance of the bonds.issuance of the bonds.


10-29Bonds Issued at a DiscountFinancial Statement Presentation

The discount The discount will be will be

amortizedamortized over the 10-over the 10-

year life of the year life of the bonds.bonds.


10-30Bonds Issued at a Discount

The issuer must pay 100,000$ when the bond The issuer must pay 100,000$ when the bond matures, but received only 88,530$ when the matures, but received only 88,530$ when the

bond was issued!bond was issued!

The extra cash that must be paid to The extra cash that must be paid to bondholders is put as an adjustment to the bondholders is put as an adjustment to the

interest expense.interest expense.

To adjust the interest expense, the issuer To adjust the interest expense, the issuer amortizes the bond discount to each interest amortizes the bond discount to each interest

period as an increase in interest expense.period as an increase in interest expense.



Two methods Two methods of amortization of amortization are commonly are commonly

used:used:Straight-lineStraight-line

ororEffective Effective

Interest MethodInterest Method


10-32Straight-Line Amortization of Bond Discount

Identify the amount of the Identify the amount of the bond discount.bond discount.

Divide the bond discount by Divide the bond discount by the number of interest the number of interest periods.periods.

Include the discount Include the discount amortization amount as part amortization amount as part of the periodic interest of the periodic interest expense entry.expense entry.The discount will be reduced The discount will be reduced

to zero by the maturity date.to zero by the maturity date.



Harrah’s issued their bonds on Jan. 1, 2003. The Harrah’s issued their bonds on Jan. 1, 2003. The discount was $11,470. The bonds have a 10-year discount was $11,470. The bonds have a 10-year maturity and $5,000 interest is paid semiannually.maturity and $5,000 interest is paid semiannually.

Compute the periodic discount amortization Compute the periodic discount amortization using the straight-line method. using the straight-line method.



Harrah’s issued their bonds on Jan. 1, 2003. The Harrah’s issued their bonds on Jan. 1, 2003. The discount was $11,470. The bonds have a 10-year discount was $11,470. The bonds have a 10-year maturity and $5,000 interest is paid semiannually.maturity and $5,000 interest is paid semiannually.

Compute the periodic discount amortization Compute the periodic discount amortization using the straight-line method. using the straight-line method.


10-35Straight-Line Amortization of Bond DiscountPrepare the journal entry to record the payment Prepare the journal entry to record the payment

of interest and the discount amortization for of interest and the discount amortization for the six months ending on June 30, 2003.the six months ending on June 30, 2003.



As the discount is

amortized, the carrying

amount of the bonds

increases.


10-37Bonds Issued at a Discount

In each interest period, the book value of In each interest period, the book value of the bonds increases by 574$ because the the bonds increases by 574$ because the unamortized bond discount decreases by unamortized bond discount decreases by

574$.574$.At maturity date, the unamortized bond At maturity date, the unamortized bond

discount is zero.discount is zero.At maturity date, the maturity amount of At maturity date, the maturity amount of bonds and the book value are the same: bonds and the book value are the same:

100,000$100,000$


10-38

Zero Coupon Bonds

Zero coupon bonds do not pay periodic interest.

Because there is no interest annuity . . .

This is called a deep discount deep discount bond because it sells for less than its maturity value.

PV of the Principal = Issue Price of the Bonds


10-39

Zero Coupon Bonds

Zero coupon bonds issued for 100,000$ for 10 years, the market rate is 10%. The issue price will be:

PV=100,000/(1+0.10)10=38,554$


10-40

Issuing Bonds at a Premium

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10-41


On January 1, 2003, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The

bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually.

Are Harrah’s bonds issued at Are Harrah’s bonds issued at par, at a discount, or at a par, at a discount, or at a

premium?premium?


10-42


On January 1, 2003, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The

bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually.

> >

Let’s compute the issue price of the bonds.


10-43



PV=100,000/(1+0.04)20=45,640$

Use the market rate of 8% to determine present value. Interest is paid semiannually, so the rate is r = 4.0% (8%

÷ 2 interest periods per year).

The maturity period is 10 years, there are 2 interest periods per year. For the present value computation,

use n=20 (10 years × 2 periods).


10-44



The semiannual interest payment is computed as:

$100,000 × 10% × 6/12

= $5,000


10-45



$952,67)04.01(04.0

104.01000,5 20

PV

Use the same r=4.0% and n=20 that were used to compute the present value of the

principal.


10-46


3.3. Compute the present value of the Compute the present value of the interest payments.interest payments.

The $113,592 is greater than the face amount of $100,000, so the bonds are issued at a premium

of $13,592.


10-47


4.4. Prepare the journal entry to record the Prepare the journal entry to record the issuance of the bonds at a premium.issuance of the bonds at a premium.

This is called an adjunct account and appears in the liability section.


10-48Bonds Issued at a PremiumFinancial Statement Presentation

The The premium will premium will be be amortizedamortized over the 10-over the 10-year life of year life of

the bonds to the bonds to each interest each interest

period.period.


10-49Straight-Line Amortization of Bond Premium

Identify the amount of the Identify the amount of the bond premium.bond premium.

Divide the bond premium by Divide the bond premium by the number of interest the number of interest periods.periods.

The premium amortization The premium amortization amount is subtracted from the amount is subtracted from the interest payment to calculate interest payment to calculate interest expense. interest expense.


10-50Straight-Line Amortization of Bond Premium

Harrah’s issued their bonds on Jan. 1, 2003. The Harrah’s issued their bonds on Jan. 1, 2003. The premium was $13,592. The bonds have a 10-year premium was $13,592. The bonds have a 10-year maturity and $5,000 interest is paid semiannually.maturity and $5,000 interest is paid semiannually.

Compute the periodic premium amortization Compute the periodic premium amortization using the straight-line method. using the straight-line method.


10-51Straight-Line Amortization of Bond PremiumPrepare the journal entry to record the payment Prepare the journal entry to record the payment

of interest and the premium amortization for of interest and the premium amortization for the six months ending on June 30, 2003.the six months ending on June 30, 2003.


10-52Bonds Issued at PremiumFinancial Statement Presentation

As the premium is

amortized, the carrying

amount of the bonds

decreases.


10-53

Bonds Issued at Premium

At maturity date, the bond premium is At maturity date, the bond premium is fully amortized.fully amortized.

At maturity date, the maturity amount of At maturity date, the maturity amount of bonds and the book value are the same: bonds and the book value are the same:

100,000$100,000$


10-54Effective-Interest Amortization of Bond Discounts and Premiums

Bond Carrying Value × Market RateBond Carrying Value × Market Rate

The effective-interest method computes interest as:

Principal amount of the bonds less any unamortized discount or plus any unamortized premium.


10-55Effective-Interest Amortization of Bond Discounts and Premiums

This is the same market rate This is the same market rate used to determine the used to determine the

present value of the bond.present value of the bond.

Bond Carrying Value × Market RateBond Carrying Value × Market Rate

The effective-interest method computes interest as:


10-56Effective-Interest Method of a bond discount

Recall our first example of Harrah’s. On Jan. 1, 2003, the company issues $100,000 in bonds having a stated rate

of 10% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 12%

annually.



Interest is paid semi-annually, so the market

rate is 12% ÷ 2 = 6%.

The cash paid to bond holders for interest is

$5,000 ($100,000 × 10% ×6/12)



The journal entry to record the first interest payment is:

The amount of the discount that has been amortized is the difference between the interest expense and the cash paid.


10-59Effective-Interest Method of a bond discountThe new bond carrying value of the next

interest payment period is:

The amortization of the bond discount increases the bond book value!


10-60Understanding the amortization of a bond discount

The amortization of a bond discount can The amortization of a bond discount can be thought of as interest earned by bond be thought of as interest earned by bond

holders but not paid to them.holders but not paid to them.During the first 6 months of 2003, the During the first 6 months of 2003, the

bond holders earned an interest of 5,312$ bond holders earned an interest of 5,312$ but received only 5,000$.but received only 5,000$.

The additional 312$ was added to the The additional 312$ was added to the principal and will be paid to bond holders principal and will be paid to bond holders

when the bond matures!when the bond matures!


10-61Understanding the amortization of a bond discount

In the second 6 months of 2003:In the second 6 months of 2003:Interest expense=88,842$*0.06=5,330$Interest expense=88,842$*0.06=5,330$5,330-5,000=330$ (amortized discount)5,330-5,000=330$ (amortized discount)


10-62

The new bond carrying value of the next interest payment period is:

Understanding the amortization of a bond discount


10-63Effective-Interest Method of a bond premium

Recall our second example of Harrah’s. On Jan. 1, 2003, the company issues $100,000 in bonds having a stated

rate of 10% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8%

annually.



Interest is paid semi-annually, so the market

rate is 8% ÷ 2 = 4%.

The cash paid to bond holders for interest is

$5,000 ($100,000 × 10% ×6/12)



The journal entry to record the first interest payment is:

The amount of the premium that has been amortized is the difference between the cash paid and the interest expense.


10-66Effective-Interest Method of a bond premiumThe new bond carrying value of the next

interest payment period is:

The amortization of the bond premium decreases the bond book value!


10-67Understanding the amortization of a bond premium

In the second 6 months of 2003:In the second 6 months of 2003:Interest expense=113,136$*0.04=4,525$Interest expense=113,136$*0.04=4,525$5,000-4,525=475$ (amortized premium)5,000-4,525=475$ (amortized premium)


10-68

The new bond carrying value of the next interest payment period is:

The amortization of the bond premium decreases the bond book value!

Understanding the amortization of a bond premium


10-69Understanding Alternative Amortization Methods

Effective-interest method of amortization is preferred by GAAP.

Straight-line amortization may be used if it is not materially different from effective interest amortization.


10-70Understanding Alternative Amortization Methods Straight-line amortization

The discount or premium is amortized in equal amounts each period.

Effective interest amortizationThe discount or premium is amortized over the

life of the debt.The interest expense is equal to the market

interest rate (at the time of issuance) multiplied by the amount of debt outstanding at the beginning of the given period.

The difference between the interest expense and the cash paid (for interest payments) represents the amortization of the discount or premium.


10-71

Early Retirement of Debt

Occasionally, the issuing Occasionally, the issuing company will call (repay company will call (repay early) some or all of its early) some or all of its bonds.bonds.

Gains/losses incurred as a Gains/losses incurred as a result of retiring bonds (book result of retiring bonds (book value of debt-market value of value of debt-market value of debt) should be reported as debt) should be reported as an extraordinary item on the an extraordinary item on the income statement.income statement.


10-72

Early Retirement of Debt


10-73

Focus on Cash Flows

Financing activities –Issuance of bonds (a cash

inflow)Retire debt (a cash outflow)Repay bond principal at

maturity (a cash outflow)


10-74

End of Chapter 10

Chap 010

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