1.Financing Corporations

1
Power Notes
Chapter 14
Bonds Payable and Investments in Bonds
Learning Objectives

• 1. Financing Corporations
• 2. Characteristics of Bonds Payable
• 3. The Present-Value Concept and Bonds Payable
• 4. Accounting for Bonds Payable
• 5. Bond Sinking Funds
• 6. Bond Redemption
• 7. Investments in Bonds
• 8. Corporation Balance Sheet
• 9. Financial Analysis and Interpretation

C14
2
Power Notes
Chapter 14
Bonds Payable and Investments in Bonds
Slide Power Note Topics

• Long-Term Financing
• Characteristics of Bonds Payable
• Time Value of Money
• Issuing Bonds Payable
• Redemption of Bonds Payable
• Investments in Bonds
• Number of Times Interest Earned

3 9 17 28 34 35 36
Note To select a topic, type the slide and
press Enter.
3
Two Methods of Long-Term Financing
Resources Sources
Liabilities
Assets
Stockholders Equity
4
Two Methods of Long-Term Financing
Resources Sources
Liabilities
Assets
Stockholders Equity
Equity Financing Stockholders
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Two Methods of Long-Term Financing
Resources Sources
Liabilities
Debt Financing Bondholders
Bondholders
Assets
Stockholders Equity
Equity Financing Stockholders
6
Two Methods of Financing
Stockholders
Bondholders
Why issue bonds rather than stock?

• Bonds (debt) Interest payments to bondholders
  are an expense that reduces taxable income.
• Stock (equity) Dividend payments are made from
  after tax net income and retained earnings.
• Earnings per share on common stock can often be
  increased by issuing bonds rather than additional
  stock.

7
Alternative Financing Plans 800,000 Earnings
Plan 1 Plan 2 Plan 3 12 bonds 2,000,000 P
referred 9 stock, 50 par 2,000,000 1,000,000
Common stock, 10 par 4,000,000 2,000,000 1,000,0
00 Total 4,000,000 4,000,000 4,000,000 Earnings
before interest and income tax 800,000
800,000 800,000 Deduct interest on
bonds 240,000 Income before income tax
800,000 800,000 560,000 Deduct income
tax 320,000 320,000 224,000 Net income
480,000 480,000 336,000 Dividends on
preferred stock 180,000 90,000 Available for
dividends 480,000 300,000 246,000 Shares
of common stock ??400,000 ??200,000 ??100,000

• Earnings per share 1.20 1.50 2.46

8
Alternative Financing Plans 440,000 Earnings
Plan 1 Plan 2 Plan 3 12 bonds 2,000,000 P
referred 9 stock, 50 par 2,000,000 1,000,000
Common stock, 10 par 4,000,000 2,000,000 1,000,0
00 Total 4,000,000 4,000,000 4,000,000 Earnings
before interest and income tax 440,000
440,000 440,000 Deduct interest on
bonds 240,000 Income before income tax
440,000 440,000 200,000 Deduct income
tax 176,000 176,000 80,000 Net income 264,000
264,000 120,000 Dividends on preferred
stock 180,000 90,000 Available for dividends
264,000 84,000 30,000 Shares of common
stock ??400,000 ??200,000 ??100,000

• Earnings per share 0.66 0.42 0.30

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Characteristics of Bonds Payable

• Long-term debt repayable 10, 20, or 30 years
  after date of issuance.
• Issued in face (principal) amounts of 1,000, or
  multiples of 1,000.
• Contract interest rate is fixed for term (life)
  of the bond.
• Face amount of bond repayable at maturity date.

10
Bond Variables and Constants

• 1. Constants fixed by bond contract.
• a. Principal (face) amount.
• b. Contract rate of interest.
• c. Term (life) of the bond.
• 2. Variables determined in the bond market.
• a. Market price of the bond.
• b. Market (effective) interest rate.

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How are Bond Prices Determined
The selling price of bonds are based on two
amounts.

• 1. Present Value of Face Amount
• The present value of the face amount (constant)
  of the bond at its maturity date, based on the
  current market interest rate (variable).
• 2. Present Value of Interest Payments
• The present value of the periodic interest
  payments (constant) for the term of the bonds,
  based on the current market interest rate
  (variable).

12
Market and Contract Interest Rates
Differences in market and bond contract interest
rates result in Discounts and Premiums.
When Bonds sell at Market rate Contract
rate Market rate gt Contract rate Market rate
lt Contract rate

• Face value
• Discount
• Premium

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Cash Flow of Bonds Payable
On January 1, 100,000 of 12, five-year bonds,
with interest of 6,000 payable semiannually are
issued. Market rate is 13 at date of issue.
Present Values
Cash Outflows Interest payments 60,000
43,133 (10 periods at 6,000) Face
amount 100,000 53,273 (at end of 5
years) 160,000 96,403 Cash Inflows Selling
proceeds 96,406 96,406
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Cash Flow of Bonds Payable
On January 1, 100,000 of 12, five-year bonds,
with interest of 6,000 payable semiannually are
issued. Market rate is 13 at date of issue.
Present Values
Cash Outflows Interest payments 60,000
43,133 (10 periods at 6,000) Face
amount 100,000 43,133 (at end of 5
years) 160,000 96,403 Cash Inflows Selling
proceeds 96,403 96,403
Present value of an annuity of 6,000 for 10
periods at a market rate of 6.5 per period is
43,133. Payment x Factor Present Value
6,000 x 7.1888 43,133
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Cash Flow of Bonds Payable
On January 1, 100,000 of 12, five-year bonds,
with interest of 6,000 payable semiannually are
issued. Market rate is 13 at date of issue.
Present Values
Cash Outflows Interest payments 60,000
43,133 (10 periods at 6,000) Face
amount 100,000 53,273 (at end of 5
years) 160,000 96,403 Cash Inflows Selling
proceeds 96,403 96,403
Present value of 100,000 paid at the end of 10
six-month periods at a market rate of 6.5 per
period is 53,273. Payment x Factor Present
Value 100,000 x .53273 53,273
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Cash Flow of Bonds Payable
On January 1, 100,000 of 12, five-year bonds,
with interest of 6,000 payable semiannually are
issued. Market rate is 13 at date of issue.
Present Values
Cash Outflows Interest payments 60,000
43,133 (10 periods at 6,000) Face
amount 100,000 53,273 (at end of 5
years) 160,000 96,406 Cash Inflows Selling
price 96,406
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The Time Value of Money Future Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.
Present Value
1,000
What is the future value of 1,000 invested today
(present value) at 8 per year?
Future Value
????
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The Time Value of Money Future Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.
Present Value
1,000
What is the future value of 1,000 invested today
(present value) at 8 per year?
1,000 (1,000 x 8) 1,000 x 108 or 1.08
Future Value
1,080
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The Time Value of Money Present Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.
Present Value
????
What is the present value of 1,000 to be
received one year from today at 8 per year?
Future Value
1,000
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The Time Value of Money Present Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.
Present Value
1,000 / 108 or 1.08
925.93
What is the present value of 1,000 to be
received one year from today at 8 per year?
Future Value
1,000
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Calculating Present Values
Present values can be determined using present
value tables, mathematical formulas, calculators
or computers.
Present value of 1 with Compound Interest
PV Table Period 6
Calculator
1 .9434 1.0000 / 1.06
One dollar at the end of one period at 6 per
period is equal to .9434 today (present value).
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Calculating Present Values
Present values can be determined using present
value tables, mathematical formulas, calculators
or computers.
Present value of 1 with Compound Interest
PV Table Period 6
Calculator
1 .9434 1.0000 / 1.06 2 .8900 .9434 / 1.06
One dollar at the end of two periods at 6 per
period is equal to .8900 today (present
value). To use the value from the prior period as
the starting point, dont clear your calculator.
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Calculating Present Values
Present values can be determined using present
value tables, mathematical formulas, calculators,
or computers.
Present value of 1 with Compound Interest
PV Table Period 6
Calculator
1 .9434 1.0000 / 1.06 2 .8900 .9434 /
1.06 3 .8396 .8900 / 1.06
One dollar at the end of three periods at 6 per
period is equal to .8396 today (present value).
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Calculating Present Values
Present values can be determined using present
value tables, mathematical formulas, calculators
or computers.
Present value of 1 with Compound Interest
PV Table Period 6
Calculator
1 .9434 1.0000 / 1.06 2 .8900 .9434 /
1.06 3 .8396 .8900 / 1.06 4 .7921
.8396 / 1.06 5 .7432 .7921 /
1.06 6 .7050 .7432 / 1.06
When using a calculator, learn to use constant
division. You will then enter 1 and 1.06 the
first time, pressing only the equal () key for
each successive answer.
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Calculating Present Values of Annuities
Annuities represent a series of equal amounts to
be paid or received in the future over equal
periods.
Present value of 1 Annuity of 1
PV Table Annuity Period 6 6
Calculation Sum of Periods
1 .9434 .9434 Period 1 2 .8900 1.8334 Periods
12 3 .8396 2.6730 Periods 13 4 .7921 3.4651
Periods 14 5 .7432 4.2124 Periods
15 4.2124
The PV of an annuity of 1 to be received each
year for two years is 1.8334. This is the sum of
the PV of the two amounts for periods 1 and 2.
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Calculating Present Values of Annuities
Annuities represent a series of equal amounts to
be paid or received in the future over equal
periods.
Present value of 1 Annuity of 1
PV Table Annuity Period 6 6
Calculation Sum of Periods
1 .9434 .9434 Period 1 2 .8900 1.8334 Periods
12 3 .8396 2.6730 Periods 13 4 .7921 3.4651
Periods 14 5 .7432 4.2124 Periods
15 4.2124
The PV of an annuity of 1 to be received each
year for three years is 2.6730. This is the sum
of the PV of the three amounts for periods 13.
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Calculating Present Values of Annuities
Annuities represent a series of equal amounts to
be paid or received in the future over equal
periods.
Present value of 1 Annuity of 1
PV Table Annuity Period 6 6
Calculation Sum of Periods
1 .9434 .9434 Period 1 2 .8900 1.8334 Periods
12 3 .8396 2.6730 Periods 13 4 .7921 3.4651
Periods 14 5 .7473 4.2124 Periods
15 4.2124
Total
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Bonds Issued at Face Amount
On January 1, 100,000 of 12, five-year bonds,
with interest of 6,000 payable semiannually are
issued. Market rate is 12 at date of issue.
Date Description Debit Credit

• Cash 100,000
• Bonds Payable 100,000
• PV of face due in 5 years (100,000 x 0.55840)
  55,840
• PV of 1 for 10 periods at 6
• PV of 10 interest payments (6,000 x 7.36009)
  44,160
• PV of annuity of 1 for 10 periods at 6
• Total selling price 100,000

Jan. 1
Issued 12, five-year bonds at face.
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Bonds Issued at a Discount
On January 1, 100,000 of 12, five-year bonds,
with interest of 6,000 payable semiannually are
issued. Market rate is 13 at date of issue.
Date Description Debit Credit

• Cash 96,406
• Discount on Bonds Payable 3,594
• Bonds Payable 100,000
• PV of face due in 5 years (100,000 x 0.53273)
  53,273
• (PV of 1 for 10 periods at 6.5)
• PV of 10 interest payments (6,000 x 7.18883)
  43,133
• (PV of annuity of 1 for 10 periods at 6.5)
• Total selling price 96,406

Jan. 1
Issued 12, five-year bonds at a discount.
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Amortization of a Bond Discount
The straight-line method amortizes bond discount
in equal periodic amounts.
Date Description Debit Credit
Cash 96,406 Discount on Bonds
Payable 3,594 Bonds Payable 100,000
Jan. 1
Issued 12, five-year bonds at a discount.

• Interest Expense 6,359.70
• Discount on Bonds Payable 359.70
• Cash 6,000.00

Jun. 30
Payment of semiannual interest and amortization
of 1/10 of bond discount.
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Bonds Issued at a Premium
On January 1, 100,000 of 12, five-year bonds,
with interest of 6,000 payable semiannually are
issued. Market rate is 11 at date of issue.
Date Description Debit Credit

• Cash 103,769
• Bonds Payable 100,000
• Premium on Bonds Payable 3,769
• PV of face due in 5 years (100,000 x 0.58543)
  58,543
• (PV of 1 for 10 periods at 5.5)
• PV of 10 interest payments (6,000 x 7.53763)
  45,226
• (PV of annuity of 1 for 10 periods at 5.5)
• Total PV (selling price) 103,769

Jan. 1
Issued 12, five-year bonds at a premium.
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Amortization of a Bond Premium
The straight-line method amortizes bond premium
in equal periodic amounts.
Date Description Debit Credit
Cash 103,769 Bonds Payable 100,000 Premium
on Bonds Payable 3,769
Jan. 1
Issued 12, five-year bonds at a premium.

• Interest Expense 5,623.10
• Premium on Bonds Payable 376.90
• Cash 6,000.00

Jun. 30
Payment of semiannual interest and amortization
of 1/10 of bond premium.
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Zero-Coupon Bonds
Zero-coupon bonds do not provide for interest
payments. Only the face amount is paid at
maturity. Assume market rate is 13 at date of
issue.
Date Description Debit Credit

• Cash 53,273
• Discount on Bonds Payable 46,727
• Bonds Payable 100,000
• PV of face due in 5 years (100,000 x 0.53273)
  53,273
• (PV of 1 for 10 periods at 6.5)
• An investment of 53,273 today would yield
  100,000 in five years compounded semiannually at
  6.5.

Jan. 1
Issued 100,000 five-year zero-coupon bonds.
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Bond Redemption
A corporation may call or redeem its bonds before
they mature. Assume a bond issue of 100,000 and
an unamortized premium of 4,000. Carrying value
is 96,000 and one-fourth of the bonds are
purchased.
Date Description Debit Credit

• Bonds Payable 25,000
• Premium on Bonds Payable 1,000
• Gain on Redemption of Bonds 2,000
• Cash 24,000

Jun. 30
Redeemed one-fourth of the total bonds.
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Investments in Bonds
Bonds are purchased directly from the issuing
corporation or through an organized bond
exchange. Bond prices are quoted as a percentage
of the face amount.
Date Description Debit Credit

• Investment in Bonds 1,025.30
• Interest Revenue 10.20
• Cash 1,035.50
• Investors do not usually record premium (or
  discount) in separate accounts because bonds
  are not often held until maturity.

Apr. 2
Purchased a 1,000 bond at 102 plus a brokerage
fee of 5.30 and accrued interest of 10.20
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Solvency Measures The Long-Term Creditor
Number of Times Interest Charges Earned
2003 2002
Income before income tax 900,000
800,000 Add interest expense 300,000
250,000 Amount available for interest 1,200,000
1,050,000
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Solvency Measures The Long-Term Creditor
Number of Times Interest Charges Earned
2003 2002
Income before income tax 900,000
800,000 Add interest expense 300,000
250,000 Amount available for interest 1,200,000
1,050,000 Number of times earned 4.0 times 4.2
times
Use To assess the risk to debtholders in terms
of number of times interest charges were earned.
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Power Notes
Chapter 14
Bonds Payable and Investments in Bonds
This is the last slide in Chapter 14.