Bonds Payable

1
Bonds Payable Investment in Bonds

• Module 1
• ACG 2071
• Created by Prof. M. Mari

2
Bonds

• A form of interest bearing note
• Requires periodic interest payments
• The face amount must be repaid at the maturity
  date
• Bondholders are creditors of the issuing
  corporation

3
Corporate Financing

• Corporations needs to decide how to acquire cash
  for operations
• They can
• Issue common stock
• Issue preferred stock
• Issue bonds
• Or any combination
• Decision is based on how it affects EPS

4
Characteristics of Bonds

• Bond Indenture
• Contract with bondholders
• Bond issue is divided into a number of individual
  bonds
• Principal
• Face value of the bonds

• Interest
• Payable annually, semiannually, or quarterly
• Coupon rate stated in the bond
• Price of bond
• Quoted as a percentage of the bonds face value

5
Types of Bonds

• Term bonds
• All are due at the same time
• Serial bonds
• Parts of the bond issue are due at different
  times
• Convertible bonds
• Exchanged for stock

• Callable bonds
• Can be redeemed before maturity date
• Debenture bonds
• Based on general credit of corporation
• Bearer bonds
• Possession is ownership

6
Price of Bonds

• Depends on
• Face amount of the bonds
• Periodic interest or coupon rate
• Market rate of interest

7
How is price computed?

• 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
• Present value is the time value of money

8
Time value of Money

• What is the value of 110 in one year if you earn
  10 on your money?
• Interest is 100 x 10 10
• Therefore the present value of 110 is 100

9
Present Value of 1 Table
Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n). Present value interest factor of 1 per period at i for n periods, PVIF(i,n).
Period 5 5.50 6.00 6.50 7 10 11 12 13 14
1 0.95238 0.94787 0.94340 0.93897 0.93458 0.90909 0.90090 0.89286 0.88496 0.87719
2 0.90703 0.89845 0.89000 0.88166 0.87344 0.82645 0.81162 0.79719 0.78315 0.76947
3 0.86384 0.85161 0.83962 0.82785 0.81630 0.75131 0.73119 0.71178 0.69305 0.67497
4 0.82270 0.80722 0.79209 0.77732 0.76290 0.68301 0.65873 0.63552 0.61332 0.59208
5 0.78353 0.76513 0.74726 0.72988 0.71299 0.62092 0.59345 0.56743 0.54276 0.51937
6 0.74622 0.72525 0.70496 0.68533 0.66634 0.56447 0.53464 0.50663 0.48032 0.45559
7 0.71068 0.68744 0.66506 0.64351 0.62275 0.51316 0.48166 0.45235 0.42506 0.39964
8 0.67684 0.65160 0.62741 0.60423 0.58201 0.46651 0.43393 0.40388 0.37616 0.35056
9 0.64461 0.61763 0.59190 0.56735 0.54393 0.42410 0.39092 0.36061 0.33288 0.30751
10 0.61391 0.58543 0.55839 0.53273 0.50835 0.38554 0.35218 0.32197 0.29459 0.26974
10
Present Value of Periodic Bond Interest Payments

• It is the value today of the amount of interest
  paid over the life of the bond
• Annuity series of equal cash payments

11
Present Value of Annuity Table
Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n). Present value interest factor of an (ordinary) annuity of 1 per period at i for n periods, PVIFA(i,n).
Period 5.00 5.50 6.00 6.50 7.00 10.00 11.00 12.00 13.00 14.00
1 0.95238 0.94787 0.94340 0.93897 0.93458 0.90909 0.90090 0.89286 0.88496 0.87719
2 1.85941 1.84632 1.83339 1.82063 1.80802 1.73554 1.71252 1.69005 1.66810 1.64666
3 2.72325 2.69793 2.67301 2.64848 2.62432 2.48685 2.44371 2.40183 2.36115 2.32163
4 3.54595 3.50515 3.46511 3.42580 3.38721 3.16987 3.10245 3.03735 2.97447 2.91371
5 4.32948 4.27028 4.21236 4.15568 4.10020 3.79079 3.69590 3.60478 3.51723 3.43308
6 5.07569 4.99553 4.91732 4.84101 4.76654 4.35526 4.23054 4.11141 3.99755 3.88867
7 5.78637 5.68297 5.58238 5.48452 5.38929 4.86842 4.71220 4.56376 4.42261 4.28830
8 6.46321 6.33457 6.20979 6.08875 5.97130 5.33493 5.14612 4.96764 4.79877 4.63886
9 7.10782 6.95220 6.80169 6.65610 6.51523 5.75902 5.53705 5.32825 5.13166 4.94637
10 7.72173 7.53763 7.36009 7.18883 7.02358 6.14457 5.88923 5.65022 5.42624 5.21612
12
Computing the Price of a Bond

• Based on the present value of the face of the
  bond
• Based on the present value of interest payments
• When using the market rate of interest

13
Computing the Price of a Bond

• Steps to Compute Price of Bond
• Compute the Present Value of the face of the bond
• Interest is rate applied is the market rate ( r )
  of interest divided by the number of interest
  payments in one year (Periods).
• Use the present value of 1 table
• FACE X PV PV of FACE
• Compute the Present Value of the Interest
  payments
• Interest is rate applied is the market rate ( r )
  of interest divided by the number of interest
  payments in one year (Periods).
• Use the present value of annuity table
• Interest payment X PVA PV of Interest payments
• Sum of the two is the PRICE OF THE BOND

14
Bonds Sells at Face Value

• Market interest rate Coupon rate
• Example Suppose that we sell 200,000 of 11
  bonds with interest paid semiannually for five
  years. The market interest rate is 11. What is
  price of the bonds

15
Computing Price

• PV of the Face of Bonds
• 200,000 X PV( r 11/2, Periods 5yrs X 2)
• divide interest rate by 2 since interest
  is paid semiannually then multiply periods by 2
  because two payment per year.
• 200,000 x .58543 117,086

Found in the present value of 1 table under P
10 and R 5.5
16
Computing Price of Bond

• PV of interest payments
• 200,000 x 11
• 22,000 annual interest payment
• Paid semiannually so each payment is 11,000.
• 11,000 X PVA( r 11/2, P 5x2)
• 11,000 x 7.53763 82,914

Found in the present value of annuity table with
p 10 and r 5.5
17
Computing price of bonds

• PV of Face 117,086
• PV of Interest payments 82,914
• Price of bond 200,000
• Will always equal face value if market rate
  coupon rate.

18
Bonds Sells above Face Value

• Market interest rate ltCoupon rate
• Example Suppose that we sell 200,000 of 11
  bonds with interest paid semiannually for five
  years. The market interest rate is 10. What is
  price of the bonds

19
Computing Price

• PV of the Face of Bonds
• 200,000 X PV( r 10/2, Periods 5yrs X 2)
• divide interest rate by 2 since interest
  is paid semiannually then multiply periods by 2
  because two payment per year.
• 200,000 x .61391 122,782

Found in the present value of 1 table under P
10 and R 5
20
Computing Price of Bond

• PV of interest payments
• 200,000 x 11
• 22,000 annual interest payment
• Paid semiannually so each payment is 11,000.
• 11,000 X PVA( r 10/2, P 5x2)
• 11,000 x 7.72174 84,939

Found in the present value of annuity table with
p 10 and r 5
21
Computing price of bonds

• PV of Face 122,782
• PV of Interest payments 84,939
• Price of bond 207,721
• Face 200,000
• Premium 7,721
• Since market is less than coupon rate, bonds sell
  above face and we have a PREMIUM

22
Bonds Sells below Face Value

• Market interest rate gt Coupon rate
• Example Suppose that we sell 200,000 of 11
  bonds with interest paid semiannually for five
  years. The market interest rate is 12. What is
  price of the bonds

23
Computing Price

• PV of the Face of Bonds
• 200,000 X PV( r 12/2, Periods 5yrs X 2)
• divide interest rate by 2 since interest
  is paid semiannually then multiply periods by 2
  because two payment per year.
• 200,000 x .55840 111,680

Found in the present value of 1 table under P
10 and R 6
24
Computing Price of Bond

• PV of interest payments
• 200,000 x 11
• 22,000 annual interest payment
• Paid semiannually so each payment is 11,000.
• 11,000 X PVA( r 12/2, P 5x2)
• 11,000 x 7.36009 80,961

Found in the present value of annuity table with
p 10 and r 6
25
Computing price of bonds

• PV of Face 111,680
• PV of Interest payments 80,961
• Price of bond 192,641
• Face 200,000
• Discount 7,359
• Since market is greater than coupon rate, we sell
  below face value at a DISCOUNT.

26
Interest rates Recap

• If the Market rate coupon rate
• BONDS sells at FACE
• If the market rate gt Coupon rate
• BONDS sells BELOW Face
• DISCOUNT
• If the market rate lt coupon rate
• BONDS sells ABOVE face
• PREMIUM

27
Accounting for Bonds

• Bonds issued at face value
• Cash DR
• Bonds payable CR
• Interest payments are recorded as
• Interest exp DR
• Cash CR

28
Bonds at Discount

• Since the price of the bond is below the face
  value, we must account for the discount incurred.

Account Debit Credit
Cash 192,641
Discount on Bonds Payable 7,359
Bonds payable 200,000
Note bonds payable account always credited The
face amount. We are liable for face value.
29
Amortization of Bond Discount

• Two methods
• Straight line method
• Allowed if results obtained do not materially
  differ from the results of the effective interest
  method
• Discount amortized Discount/ of interest
  payments
• Effective interest method
• Required by GAAP

30
Straight Line Method

• Amortization of Discount
• Discount on bonds payable
• Periods
• 7,359
• 10
• 735.90 with each interest payment

31
Discount on Bond

• Every interest payment date, an entry must be
  made to record the interest paid to bondholders
  and the amortization of bond discount. Interest
  paid to bondholders is an expense to the business

Account Debit Credit
Interest expense 11,736
Discount on bonds payable 736
Cash 11,000
Note that discount increases the interest expense.
32
Bonds issued at Premium

• Since price of bond is above the face value, we
  must account for premium

Account Debit Credit
Cash 207,721
Premium on bond payable 7,721
Bonds payable 200,000
Note that the bonds payable is always credited
for the face value of the bonds even though the
bonds sold for more.
33
Amortization of Bond Premium

• Amortization of Premium
• Premium on bonds payable
• Periods
• 7,721
• 10
• 772 with each interest payment

34
Premium
Account Debit Credit
Interest expense 10,228
Premium on bond payable 772
Cash 11,000
Premium amortization decreases interest expense.
35
Bond Sinking Fund

• at the end of the life of the bond, a large cash
  payment must be made to cover the face value of
  the bonds
• corporations may choose to transfer funds into a
  special account over the life of the bond to
  cover this payment
• called Sinking Fund
• Sinking Fund Cash
• The account created to record the transfer
• If investments are purchased with these funds,
  they are placed in
• Sinking Fund Investment Account
• If investment earn income
• Sinking Fund Revenue

36
Bond Redemption

• A corporation may call or redeem bonds before
  they mature,
• Done if market rate of interest declines
  significantly after the bonds have been issued
• Callable bonds allow for the early redemption.
• Call price is usually above the face value of the
  bond

37
Bond Redemption

• If corporation redeems bond at a price other than
  carrying value of the bonds
• Face amount of the bond less unamortized discount
• Face amount of bonds plus unamortized premium
• If redemption price is below carrying amount
• Difference is a GAIN

38
Bond Redemption

• Example Bonds with a face of 100,000, and
  unamortized premium of 5,000 are redeemed for
  102,000.

Account Debit Credit
Bonds payable 100,000
Premium on bond payable 5,000
Cash 102,000
Gain on redemption of bonds 3,000
39
Bond Redemption

• If redemption price is above carrying amount
• Difference is a LOSS
• Example Bonds with a face of 100,000, and
  unamortized discount of 4,000 are redeemed for
  98,000.

Account Debit Credit
Bonds payable 100,000
Loss on redemption of bonds 2,000
Discount on bonds payable 4,000
Cash 98,000
40
Investment in Bonds

• Bonds may be purchased either directly from the
  issuing corporation or through an organized bond
  exchange.
• Price of the bond is quoted as a percentage of
  the face value
• Bonds worth 100,000, selling at 95, means price
  is 95,000.
• Cost of bonds include all costs related to the
  purchase
• Commissions are included
• If bonds are purchased between interest dates,
  the interest accrued until the date of purchase
  is added to the purchase price
• This interest is debited to the INTEREST REVENUE
  account of the purchaser since he will receive
  the full interest on the payment date.

41
Investments in Bonds

• Example Suppose that we purchase a 10,000 bond
  at 101 plus commission of 60 and accrued
  interest of 105.00. Record the purchase.

Account Debit Credit
Investment in bonds 10,060
Interest revenue 105
Cash 10,165