Long-Term Liabilities: Bonds and Notes 12

Bond A bond is simply a form of an interest-bearing note. Like a note, a bond requires periodic interest payments, and the face amount must be repaid at the maturity date.

Huckadee Corporation is considering the following plans to issue debt and equity: 1

Earnings per share (EPS) measure the income earned by each share of common stock. It is computed as follows: Earnings per share = Net Income – Preferred Dividends Number of Common Shares Outstanding Data for Huckadee Corporation : 1.Earnings before interest and taxes are $800, The tax rate is 40%. 3.All bonds or stocks are issued at their par or face value. 1

Effect of Alternative Financing Plans—$800,000 earnings. 1 Exhibit 1

Effect of Alternative Financing Plans—$440,000 earnings. Exhibit 2

Gonzales Co., is considering the following alternative plans for financing their company: Plan 1 Plan 2 Issue 10% Bonds (at face)$2,000,000 Issue $10 Common Stock$3,000,000$1,000,000 Income tax is estimated at 40% of income. Determine the earnings per share of common stock under the two alternative financing plans, assuming income before bond interest and income tax is $750,000. Example Exercise 12-1 Alternative Financing Plans

Example Exercise 12-1 (continued) 1 Earnings before bond interest and income tax Bond interest Balance Income tax Net income Dividend on preferred stock Earnings available for common stock Number of common shares Earnings per share on common stock Plan 2Plan 1 ($750,000 × 40%) For Practice: PE 12-1A, PE 12-1B Follow My Example 12-1

Bond Characteristics and Terminology The underlying contract between the company issuing bonds and the bondholders is called a bond indenture or trust indenture. 2

Usually, the face value of each bond, called the principal, is $1,000 or a multiple of $1,000. Interest on bonds may be payable annually, semiannually, or quarterly. Most pay interest semiannually. 2 Bond Characteristics and Terminology

When all bonds of an issue mature at the same time, they are called term bonds. If the maturity dates are spread over several dates, they are called serial bonds. 2 Bond Characteristics and Terminology Bonds that may be exchanged for other securities are called convertible bonds.

Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds. 2 Bonds issued on the basis of general credit of the corporation are debenture bonds. Bond Characteristics and Terminology

The market or effective rate of interest is determined by transactions between buyers and sellers of similar bonds. The market rate of interest is affected by a variety of factors, including investors’ expectations of current and future economic conditions. Proceeds from Issuing Bonds 2

MARKET RATE = CONTRACT RATE Selling price of bond = $1,000 If the contract rate equals the market rate of interest, the bonds will sell at their face amount. 2

MARKET RATE > CONTRACT RATE – Discount If the market rate is higher than the contract rate, the bonds will sell at a discount. Selling price of bond < $1,000 2

MARKET < CONTRACT RATE + Premium If the market rate is lower than the contract rate, the bonds will sell at a premium. Selling price of bond > $1,000 2

On January 1, 2009, Eastern Montana Communications Inc. issued for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%. Bonds Issued at Face Amount 3

Since the bond rate of interest and the market rate of interest are the same, the bonds will sell at their face amount. 3

Every six months (on June 30 and December 31) after the bonds are issued, interest of $6,000 ($100,000 ×.12 × 6/12) is paid. 3

The bond matured on December 31, At this time, the corporation paid the face amount to the bondholder. 3

Installment Notes An installment note is a debt that requires the borrower to make equal periodic payments to the lender for the term of the note. Unlike bonds, a note payment consists of payment of a portion of the amount initially borrowed (the principal) and payment of interest on the outstanding balance. 4