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**Long-Term Liabilities**

Chapter 14 Long-Term Liabilities Chapter 14: Long-Term Liabilities

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**Bond Financing Advantages Disadvantages**

Bonds do not affect owner control. Bonds require payment of both periodic interest and par value at maturity. Interest on bonds is tax deductible. There are three main advantages of issuing bonds instead of stock. 1. Bonds do not affect owner control. Equity financing reflects ownership in a company, whereas bond financing does not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of all owner decisions. A person who owns a $1,000, 11%, 20-year bond has no ownership right. 2. Interest on bonds is tax deductible. Bond interest payments are tax deductible for the issuer, but equity payments to owners are not. 3. Bonds can increase return on equity. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverage or trading on the equity. On the other side of the issue, there are two main disadvantages to issuing bonds. 1. Bonds require payment of both periodic interest and the par value at maturity. Bond payments can be especially burdensome when income and cash flow are low. Equity financing, in contrast, does not require any payments because cash withdrawals (dividends) are paid at the discretion of the owner (or board of directors). 2. Bonds can decrease return on equity. When a company earns a lower return with the borrowed funds than it pays in interest, it decreases its return on equity. This downside risk of financial leverage is more likely to arise when a company has periods of low income or net losses. A company must weigh the risks and returns of the disadvantages and advantages of bond financing when deciding whether to issue bonds to finance operations. Bonds can decrease return on equity. Bonds can increase return on equity.

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Issuing Bonds at Par P1 On Jan. 1, 2011, a company issued the following bonds: Par Value: $800,000 Stated Interest Rate: 9% Interest Dates: 6/30 and 12/31 Maturity Date = Dec. 31, 2030 (20 years) On January 1, 2011, a company issues $800,000 of 9% interest 20 year with interest payable on June 30th and December 31st. The bonds mature on December 31, 2030. On the issue date, we will debit Cash and credit Bonds Payable for $800,000. The Bonds Payable account is always credited for the par value, or maturity value, of the bonds.

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**This entry is made every six months until the bonds mature.**

Issuing Bonds at Par P1 On June 30, 2011, the issuer of the bond pays the first semiannual interest payment of $36,000. On the first interest payment date, the company would debit Bond Interest Expense and credit Cash for $36,000. The interest was calculated as Par value times stated rate times months since last payment. The company will actually make this entry every six months until the maturity date. $800,000 × 9% × ½ year = $36,000 This entry is made every six months until the bonds mature.

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Issuing Bonds at Par P1 On December 31, 2030, the bonds mature and the issuer of the bond pays face value of $800,000 to the bondholders. On December 31, 2030, the bonds mature and the issuer of the bond pays face value of $800,000 to the bondholders. The Bonds Payable account is debited for $800,000 and Cash is credited for $800,000.

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**Bond Discount or Premium**

The bond’s market rate of interest is the rate that borrowers are willing to pay and lenders are willing to accept for a particular bond and its risk level. As the risk level increases, the rate increases to compensate purchasers for the bonds’ increased risk. Many bond issuers try to set a contract rate of interest equal to the market rate they expect as of the bond issuance date. When the contract rate and market rate are equal, a bond sells at par value, but when they are not equal, a bond does not sell at par value. If the contract rate is greater than the market rate, then the bonds are sold at a premium. But if the contract rate is less than the market rate, then the bonds are sold at a discount.

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**Issuing Bonds at a Discount**

P2 Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2011 Maturity Date: Dec. 31, 2013 (2 years) } Bond will sell at a discount. A discount on bonds payable occurs when a company issues bonds with a contract rate less than the market rate. This means that the issue price is less than par value. To illustrate, assume that Fila announces an offer to issue bonds with a $100,000 par value, an 8% annual contract rate (paid semiannually), and a two-year life. The market interest rate of the bonds is 10%. These bonds will sell at a discount since the contract rate is less than the market rate. The exact issue price for these bonds is stated as (implying % of par value, or $96,454); we show how to compute this issue price later.

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**Issuing Bonds at a Discount**

P2 Issuing Bonds at a Discount On Dec. 31, 2011, Fila should record the bond issue. Par value $ 100,000 Cash proceeds 96,454 Discount $ ,546 *$100,000 x % Contra-Liability Account Remember that the whole reason we offered the discount is because of the difference between the stated rate and the market rate of interest. On the issue date, Fila will debit Cash for the amount of the cash proceeds, credit Bonds Payable for the par value of the bonds issued, and debit Discount on Bonds Payable for the difference between the two. Discount on Bonds Payable is a contra-liability account and has a normal debit balance.

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**Issuing Bonds at a Discount**

P2 Maturity Value Carrying Value On the balance sheet, the amount of the unamortized discount is subtracted from the par value of the bonds to arrive at the current carrying value of the bonds. Using the straight-line method to amortize the discount, Fila will divide the amount of the discount by the number of interest payment periods during the bond’s life. Since this is a 2-year bond and it pays interest semiannually, there are 4 interest payment periods. This calculation shows that the discount amortization will be $887 at every interest payment date. Amortizing a Bond Discount Using the straight-line method, the discount amortization will be $887 (rounded) every six months. $3,546 ÷ 4 periods = $887 (rounded)

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**Amortizing a Bond Discount**

P2 Fila will make the following entry every six months to record the cash interest payment and the amortization of the discount. Every six months, Fila will make the entry to pay interest and amortize the discount on bonds payable. The credit to Cash is for $4,000, the actual amount of cash interest paid to the bondholders. Interest is calculated as par value times the stated interest rate times one half of a year. The credit to the Discount on Bonds Payable account is determined using the straight-line method we discussed on the previous slide. The debit to Bond Interest Expense is $4,887, the total of the cash paid and the amortization amount. $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 8% × ½ = $4,000

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**Issuing Bonds at a Premium**

Adidas issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 12% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2011 Maturity Date: Dec. 31, 2013 (2 years) } Bond will sell at a premium. A premium on bonds payable occurs when a company issues bonds with a contract rate greater than the market rate. This means that the issue price is more than par value. To illustrate, assume that Adidas announces an offer to issue bonds with a $100,000 par value, a 12% annual contract rate (paid semiannually), and a two-year life. The market interest rate of the bonds is 10%. These bonds will sell at a premium since the contract rate is more than the market rate. The exact issue price for these bonds is stated as (implying % of par value, or $103,546). We show how to compute this issue price later in the chapter.

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**Issuing Bonds at a Premium**

On Dec. 31, 2011, Adidas will record the bond issue as: Par value $ 100,000 Cash proceeds 103,546 * Premium $ ,546 *$100,000 x % Remember that the whole reason we offer the premium is because of the difference between the stated rate and the market rate of interest. As a result, the premium represents a reduction in the Interest Expense recorded over the life of the bond. Amortizing the premium will decrease the total Interest Expense recorded for the bond to equal 10% percent, the market rate of interest. On the issue date, Adidas will debit Cash for $103,546, the amount of the cash proceeds, credit Bonds Payable for the par value of $100,000, and credit Premium on Bonds Payable for $3,546, the difference between the two amounts. Premium on Bonds Payable is an adjunct-liability account and has a normal credit balance. Adjunct-Liability Account

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**Issuing Bonds at a Premium**

Maturity Value Carrying Value On the balance sheet, the premium account is added to the par value of the bonds to arrive at the current carrying value of the bonds. Using the straight-line method to amortize the premium, Adidas will divide the premium of $3,546, by the number of interest payment periods during the bond’s life. Since this is a 2-year bond and it pays interest semiannually, there are 4 interest payment periods. This calculation determines that the premium amortization will be $887 at every interest payment date. Amortizing a Bond Premium Using the straight-line method, the premium amortization will be $887 (rounded) every six months. $3,546 ÷ 4 periods = $887 (rounded)

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**Amortizing a Bond Premium**

Adidas will make the following entry every six months to record the cash interest payment and the amortization of the discount. Every six months, Adidas will make an entry to credit Cash for the actual amount of interest paid, $6,000, to the bondholders. This amount is determine by multiplying total par value times the stated interest rate times one half of a year, or in this case, $6,000. The debit to the Premium on Bonds Payable account is determined using the straight-line method as discussed on the previous slide. The debit to Bond Interest Expense is amount of the cash paid, $6,000, less the bond premium amortization of $887 (rounded). $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 12% × ½ = $6,000

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**Issuing Bonds at a Discount**

P2 Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: ? Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2011 Maturity Date: Dec. 31, 2013 (2 years) We have used these Fila bonds before. Let’s see how we determine the issue price of the bonds using present value computations. Recall that these bonds pay interest for 4 periods and the market rate of interest is 10% annually, or 5% semiannually. The cash interest paid is $4,000 per interest payment period. Now, let’s do some present value computations.

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**Present Value of a Discount Bond**

To calculate Present Value, we need relevant interest rate and number of periods. Semiannual rate = 5% (Market rate 10% ÷ 2) Semiannual periods = 4 (Bond life 2 years × 2) The price of the bond is made up of two factors: The present value of the par value paid at maturity. The present value of the series of interest payments over the life of the bond. For Fila, the par value is $100,000. To find the present value of the par value, we can use the Present Value of $1 from Table, B.1, or a calculator. The present value of $100,000, for 4 periods at 5% interest is $82,270, $100,000 times the present value factor To find the present value of the interest payments, we can use the Present Value of an Annuity of $1 from Table B.3, or a calculator. The Present Value of an Annuity of $1 for 4 periods at 5% interest is We multiply this present value factor times the interest annuity of $4,000 and get a present value of $14,184. Finally, we add the two present values to arrive at the $96,454 selling price of the bond. $100,000 × 8% × ½ = $4,000

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Debt-to-Equity Ratio A3 Debt-to- Equity Ratio Total Liabilities Total Equity = This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity. The Debt-to-Equity Ratio helps investors determine the risk of investing in a company’s bonds by dividing the company’s total liabilities by its total equity. A high Debt-to-Equity Ratio (over 1) indicates the company’s liabilities outweigh its equity. The lower the number, the safer the investment will be. Here is a table showing the debt-to-equity ratio for Cedar Fair for the years 2005 through Notice the 2008 debt-to-equity ratio is 19.5, meaning that debt holders contributed $19.5 for every $1 contributed by equity holders. This implies a fairly risky financing structure for Cedar Fair. Also notice how much higher the debt-to-equity ratio is for Cedar Fair as compared to the industry average.

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End of Chapter 14 End of chapter 14.

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Reporting and Interpreting Bonds Chapter 10.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Reporting and Interpreting Bonds Chapter 10.

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