Chapter 15: Bonds Payable and Investments in Bonds

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Chapter 15 Bonds Payable and Investments in
Bonds

• Instructors Lecture

P.H.
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Financing Corporations

• Corporations may finance operations by issuing
  stocks (equity financing) or bonds (debt
  financing)
• One of the many factors that influence the
  decision is the effect of each alternative on
  earnings per share

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Financing Corporations

• Assume a corporation needs to raise 4,000,000,
  and they estimate that their earnings before
  interest on bonds and taxes is 800,000
• Lets look at estimated income statements based
  on three alternative financing plans
• Plan 1 100 financing from issuing common
  stock, 10 par
• Plan 2 50 financing from issuing 9
  preferred stock, 50 par
• 50 financing from issuing common
  stock, 10 par
• Plan 3 50 financing from issuing 12 bonds
• 25 financing from issuing 9
  preferred stock, 50 par
• 25 financing from issuing common
  stock, 10 par

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Financing Corporations Plan 1100 from 10 par
Common Stock
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Financing Corporations Plan 250 from pfd. 9
stock, 50 par50 from common stock, 10 par
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Financing Corporations Plan 350 from 12
bonds25 from pfd. 9 stock, 50 par25 from
common stock, 10 par
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Financing Corporations

• As earnings before bond interest and taxes rises
  above 800,000, Plan 3 looks even better for the
  common stockholders

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Financing Corporations

• Why does Plan 3 (issuing bonds) maximize earnings
  per share?

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Financing Corporations

• Plan 3 maximizes earnings per share for common
  stockholders for 2 reasons
• bond interest payments lower taxes
• with less shares of common stock, there is more
  to distribute to each share (the earnings per
  share denominator is lower)

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Financing Corporations

• Will issuing bonds always result in the maximum
  amount of earnings per share for the common
  stockholders?

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Financing Corporations

• Follow the example in the text when the earnings
  before interest and taxes are only 440,000
• With this lower amount of earnings before
  interest and taxes, Plan 1 maximizes earnings per
  share for common stockholders

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Financing Corporations Summary

• As earnings before bond interest and taxes rises,
  bond financing becomes more desirable in terms of
  maximizing earnings per share
• As earnings before bond interest and taxes falls,
  bond financing becomes less desirable in terms of
  maximizing earnings per share

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Financing Corporations Summary

• Bond financing is riskier than equity financing
  for the issuing corporation because periodic
  interest payments and repayment of the face value
  of the bonds are legal obligations of the company

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Characteristics of Bonds Payable

• The contract between the corporation and the
  bondholders is called the bond indenture
• The face value (principle) of bonds is usually
  1,000, or multiples of 1,000
• Most bonds pay interest semiannually
• When all the bonds of an issue mature (are due)
  at the same time, they are term bonds
• If the maturities are spread over several dates,
  they are serial bonds
• Bonds that may be exchanged for other securities,
  such as common stock, are called convertible
  bonds
• Bonds that a corporation has the right to redeem
  (buy back) before their maturity are callable
  bonds

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Characteristics of Bonds Payable

• When a corporation issues bonds, the price that
  buyers are willing to pay for the bonds depends
  on the following three factors
• the face amount (or principle), which is the
  amount due at maturity (usually 1,000)
• the periodic interest to be paid (printed on the
  bond)called the coupon rate, or contract rate
• the market rate (also called the effective rate)
  of interest on bonds of similar quality

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Characteristics of Bonds Payable

• Why would the contract rate be different than the
  market rate?

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Characteristics of Bonds Payable

• Because market rates may fluctuate on a daily
  basis.
• The contract rate is the rate that is printed on
  the bond (it is the rate promised to the
  bondholders by the corporation).
• By the time the bonds reach the market, it is
  very possible that the market rate has changed.

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Characteristics of Bonds Payable

• Remember
• the contract rate is the same as the
  coupon rate
• and
• the market rate is the same as the effective rate
  of interest

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Characteristics of Bonds Payable

• When the coupon rate (is equal to) the market
  rate, the bonds will sell at their face amount
• When the coupon rate rate, the bonds will sell at a discount (less
  than face amount)
• When the coupon rate (is greater than) the
  market rate, the bonds will sell at a premium
  (more than face amount)

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Characteristics of Bonds Payable

• Why is this true?

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Characteristics of Bonds Payable

• Lets assume you were deciding between investing
  in bonds of Company A, or the bonds of Company B,
  two companies with the same bond rating.
• If Company A had a higher contract rate than
  Company B, you would choose Company A, all other
  factors being equal, because you would earn a
  higher amount of interest with Company A.
• What would entice you to invest in the bonds of
  Company B?

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Characteristics of Bonds Payable

• You might invest in the bonds of Company B if you
  could buy the bonds at a discount (an amount less
  than face value).
• Keep in mind that this means you are able to buy
  the bonds at less than face value (i.e., less
  than 1,000), but you still receive 1,000 back
  at maturity.

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Characteristics of Bonds Payable

• Similarly, bonds sell at a premium because their
  contract rate is higher than the market rate.
• In this case, you pay more than the face amount
  (i.e., more than 1,000) to purchase the bonds,
  but you still get only 1,000 back at maturity.
• Why would you purchase these bonds?
• Because you earn more interest than you would
  earn on bonds of similar quality.

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The Present-Value Concept

• The time value of money concept recognizes that
  an amount of cash to be received today is worth
  more than the same amount to be received in the
  future.
• If you had the money today, you could invest it
  at a given rate of interest, and it would grow to
  be more than its present value (value today).

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The Present-Value Concept

• In order to understand the concept of present
  value, lets review the concept of future value
• If I have 100 today (the present value), what
  will it grow to be (future value) if I can invest
  it for one year at 7?
• 100 X 1.07 107

present value
1 the interest rate
future value
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The Present-Value Concept

• What will it grow to be if I invest it for two
  years?
• 107 X 1.07
  114.49
• Note that I start with the future value after one
  year (107) and multiply this by 1 .07 to get
  the future value at the end of two years.

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The Present-Value Concept

• I use 107 because I am earning interest not only
  on the principle (100), but also on the
  interest.
• Earning interest on interest is called
  compounding
• If I am going to invest for more than 2 years, I
  can do successive calculations multiplying the
  previous years future value by 1.07.
• Or, I can use a future value table.

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The Present-Value Concept

• For example, if I invest the 100 for 10 years at
  7, I can use the future value table in Appendix
  A of the text to determine what the 100 will
  grow to by the end of the 10th year.
• Look on page A-6, and find the factor of 1.96715
  where the 10 (n\i) meets the 7.
• Multiply the factor (1.96715) by 100 (the
  present value) to get a future value of 196.15.

I will have almost doubled my money! I should
have invested more than 100!
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The Present-Value Concept

• Now, lets try to solve for present value.
• Lets say you plan to go on a cruise with your
  friends 3 years from now (after you graduate),
  and you will need to have 3,000 for this cruise.
  
• How much will you need to invest now in order to
  have 3,000 three years from now?
• in order to answer this question, you will need
  to know how much you can earn on your investment
  (the interest rate)

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The Present-Value Concept

• In this case, you already know the future value
  (3,000) what you need to know is the present
  value (how much you need to invest today in order
  to have 3,000 in three years).
• Lets assume you can earn 7 on your investment.
• We can use the mathematical approach by doing
  successive divisions.

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The Present-Value Concept

• ? X 1.07 3,000
• When you solve for the unknown number (the
  present value) using algebra, you end up dividing
  3,000 (the future value) by 1 the interest
  rate.

present value
1 the interest rate
future value
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The Present-Value Concept

• 3,000
• 1.07
• 2,803.74
• 1.07
• 2,620.32
• 1.07

2,803.74 (rounded)
1 year
2,620.32 (rounded)
2 years
3 years
2,448.90 (rounded)
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The Present-Value Concept

• You would need to invest 2,448.90 today at 7 to
  have 3,000 in 3 years.
• If you use the present value table in your text
  (page A-2) you should find the factor of .81630
  where the n\i of 3 meets the 7 column.
• When you multiply the factor of .81630 by 3,000,
  you get a present value of 2,448.90.

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The Present-Value Concept and Bonds Payable

• What does the concept of present value have to do
  with bonds payable?

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The Present-Value Concept and Bonds Payable

• The face amount of the bonds and the periodic
  interest on the bonds represent cash to be
  received by the buyer in the future.
• The buyer determines how much to pay for the
  bonds by computing the present value of these
  future cash receipts using the market rate of
  interest.

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Accounting for Bonds PayableBonds Issued at Face
Amount

• Assume that on January 1, 2002, a corporation
  issues for cash 100,000 of 12 (contract rate),
  five-year bonds, at a market (effective) interest
  rate of 12.
• Since the contract (coupon) rate of 12 is equal
  to the market (effective) rate of 12, the bonds
  will sell at face value (100,000).

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Accounting for Bonds PayableBonds Issued at Face
Amount
find this factor in the present value of 1
table where 10 periods intersects with 6. Use
10 periods because, although it is a 5-year bond,
interest is compounded semiannually. Use 6
because the 12 market rate is an annual rate, so
the interest rate for 6 months is half of 12.
the amount of the interest payment is
calculated based on the contract rate of 12.
Since it is a semiannual payment, 6 of 100,000
will be paid to bondholders every 6 months.
Find this factor in the present value of an
annuity table where 10 periods intersects with 6.
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Accounting for Bonds PayableBonds Issued at Face
AmountJournal Entries Issuance
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Accounting for Bonds PayableBonds Issued at Face
AmountJournal Entries First payment of interest
Amount of interest to be paid 6 (.06) x
100,000
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Accounting for Bonds PayableBonds Issued at a
Discount

• If the market rate of interest is 13 and the
  contract rate is 12 on the 5-year, 100,000
  bonds, the bonds will sell at a discount.

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Accounting for Bonds PayableBonds Issued at a
Discount
find this factor in the present value of 1
table where 10 periods intersects with 6 1/2.
Use 10 periods because, although it is a 5-year
bond, interest is compounded semiannually. Use 6
1/2 because the 13 market rate is an annual
rate, so the interest rate for 6 months is half
of 13.
the amount of the interest payment is
calculated based on the contract rate of 12.
Since it is a semiannual payment, 6 of 100,000
will be paid to bondholders every 6 months.
Find this factor in the present value of an
annuity table where 10 periods intersects with 6
1/2.
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Accounting for Bonds PayableBonds Issued at a
DiscountJournal Entries Issuance
3,594 100,000 96,406
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Accounting for Bonds PayableBonds Issued at a
DiscountJournal Entries First payment of
interest
The interest expense is greater than 6,000
because the company only received 96,406, but
they have to pay back 100,000
3,594 (the total discount) /10 periods
Amount of interest to be paid 6 (.06) x
100,000
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Accounting for Bonds PayableBonds Issued at a
Discount

• If the market rate of interest is 11 and the
  contract rate is 12 on the 5-year, 100,000
  bonds, the bonds will sell at a premium.

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Accounting for Bonds PayableBonds Issued at a
Premium
find this factor in the present value of 1
table where 10 periods intersects with 5 1/2.
Use 10 periods because, although it is a 5-year
bond, interest is compounded semiannually. Use 5
1/2 because the 11 market rate is an annual
rate, so the interest rate for 6 months is half
of 11.
the amount of the interest payment is
calculated based on the contract rate of 12.
Since it is a semiannual payment, 6 of 100,000
will be paid to bondholders every 6 months.
Find this factor in the present value of an
annuity table where 10 periods intersects with 5
1/2.
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Accounting for Bonds PayableBonds Issued at a
PremiumJournal Entries Issuance
3,769 103,769 - 100,000
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Accounting for Bonds PayableBonds Issued at a
PremiumJournal Entries First payment of
interest
The interest expense is less than 6,000 because
the company received 103,769, and they only have
to pay back 100,000
3,769 (the total premium) /10 periods
Amount of interest to be paid 6 (.06) x
100,000
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Accounting for Bonds PayableGuidelines

• Remember to use the correct present value table
• Use present value of 1 for repayment of the face
  amount
• Use present value of an annuity for the interest
  payments
• If the bond pays interest semiannually, the
  number of periods to use on the table is 2 times
  the number of years to the bonds maturity
• When using the tables, always use the market rate
• If the bond pays interest semiannually, the
  amount of interest to use in the tables is ½ of
  the market rate
• To calculate the amount of the annuity (the
  interest payment), use ½ of the contract rate if
  the bond pays interest semiannually
• This is the amount that will be multiplied by the
  factor from the present value of an annuity
  table.

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Zero-Coupon Bonds

• Zero-coupon bonds do not have interest payments
• The bonds are sold at a large discount
• The accounting for zero-coupon bonds is similar
  to that for interest-bearing bonds that have been
  sold at a discount

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Bond Sinking Funds

• The bond indenture (contract with the
  bondholders) may require that the corporation
  restrict dividend payments to stockholders to
  protect the bondholders
• In addition, the bond indenture may require the
  corporation to set aside funds over the life of
  the bond issue
• the amounts set aside are kept separate from
  other assets in a special fund called a sinking
  fund
• when investments are purchased with the sinking
  fund cash, they are recorded in an account called
  Sinking Fund Investments
• any income received (interest or dividends) is
  recorded in an account called Sinking Fund Revenue

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Bond Redemption

• A corporation may call or redeem (buy back) bonds
  before they mature
• This may be done if the market rate is lower than
  the rate of interest (contract rate) that the
  corporation is paying on the bonds
• The corporation can save on future interest
  expenses by issuing new bonds at the lower rate
  and using the funds from the new issue to call
  the original issue

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Bond Redemption

• Callable bonds can be redeemed by the issuing
  corporation within the period of time and at the
  price stated on the bond indenture
• A corporation may also redeem its bonds by
  purchasing them on the open market like any other
  investor
• If the price paid for the bonds is below the bond
  carrying amount (face less unamortized discount
  or face plus unamortized premium), a gain will be
  recorded a loss will be recorded if the price
  paid for the bonds is above the bond carrying
  amount

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Investments in Bonds

• Just as corporations may invest in the stock of
  other corporations, they may also invest in the
  bonds of other corporations
• The bonds may be purchased directly from the
  issuing corporation or through an organized bond
  exchange
• Bond exchanges publish daily bond quotations, and
  include the high, low, and closing prices (quoted
  as a percentage of the face amount), maturity
  date, and volume of sales

For example, a bond quote of 105 means that the
bond is selling for 105 of face amount. If the
face amount is 1,000, then the bond is selling
for 1,050 (1.05 x 1,000). If the bond price is
93, the bond is selling for 930 (.93 x 1,000)
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Investments in Bonds

• The cost of a bond investment includes all costs
  related to the purchase (for example, brokers
  commission)
• When bonds are purchased between interest dates,
  the buyer normally pays the seller the interest
  accrued (earned) up to that date the buyer then
  receives the entire interest payment at the next
  interest payment date

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Sale of Bond Investments

• Long-term investments in bonds may be sold before
  their maturity date
• When this occurs, the seller receives the sales
  price (less commissions and other selling costs)
  plus any accrued interest since the last interest
  payment date
• The seller should amortize any discount or
  premium for the current period
• Any gain or loss on the sale is recorded when the
  cash proceeds are recorded
• such gains or losses are reported in the Other
  Income section of the income statement

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Number of Times Interest Charges Earned

• This ratio assesses the relative risk of the debt
  holders (creditors)
• The higher the ratio, the greater the chance that
  interest payments will continue to be made if
  earnings decrease
• the higher the ratio, the better it is for the
  creditors
• number of times interest charges earned
• Income before income tax Interest expense
• Interest expense