Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 17 Bonds and Long-term Notes Payable

In this chapter… Balance Sheet Current Assets Cash10000 Current Liabilities Accounts Payable Chapter 5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Bonds Bonds are a form of debt issued by a company or a government to raise money. –Usually the organization wishes to raise money to fund R&D, operations or maybe make capital asset purchases. A bond is a written promise to pay an amount identified as the par value of the bond along with interest at a stated annual rate. Par value, aka face value is the amount paid at maturity Maturity date is the date on which the total bond value amount is due Interest rate, or coupon rate is the amount of interest owed, usually quoted as an annual rate, but paid semiannually Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Debt vs Equity Financing As we saw in previous chapters, managers make decision regarding the best way of raising money: Besides selling stock, bonds offer another way: –Bonds do not affect shareholder control as it is debt This means existing shareholders may not get upset when new share are issued, thereby diluting their control –Interest owed on bonds is tax deductible (paid out of before-tax dollars) Whereas dividends are paid out of after tax dollars –Bonds can increase return on equity Since ROE = Net Income/Common Shareholder’s Equity, as long as the additional income generated by the bond exceeds interest expense, then ROE has increased Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Disadvantages of Bonds Bonds require payment of both interest and the par value at maturity. These are debt obligations Bonds have a senior claim on assets in the event of a liquidation over owner’s equity Just as bonds can increase return on equity, so also can it decrease return on equity if the company does not use the funds well. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Comparing Bonds, Notes & Mortgages All of these are debt instruments Notes: –Notes usually require the payment of interest when the principal is repaid. –There is no mid-term interest payments. Full interest is paid when the full principal is repaid Bonds: –Bonds require (usually) semi-annual interest payments –The full bond principal and the last interest payment are due at the end of the life of the bond Mortgages –Most mortgages are structured so that a portion of the principal is repaid on every payment (usually monthly, bi-monthly or bi-weekly) –The outstanding principal declines over the life of the mortgage Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Issuing Bonds When an org issues bonds to raise cash, the journal entry is: Bonds are a long-term debt instrument, so they appear on the right side of the balance sheet, below the current liabilities. When the organization goes to pay a bond interest payment: DateAccount Titles and explanationPRDebitCredit Jan 1Cash Bonds Payable DateAccount Titles and explanationPRDebitCredit Jan 1Bond Interest Expense2500 Cash2500 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Issuing Bonds When the organization pays the bond out: DateAccount Titles and explanationPRDebitCredit Jan 1Bonds Payable Cash Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Bond Pricing Bonds can be traded on an organized exchange. Bond prices fluctuate with the prime rate from the Bank of Canada and the international exchange rate. As shown in Exhibit 17.3, –if the bond’s interest rate (called a contract rate) is above the market interest rate, the bond sells at a premium (meaning it sells at a price higher than its par value) –If the bond’s contract rate is below the market rate, the bond sells at a discount (at a price below its par value) We can see the reason why when we look at how to value/price bonds: Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Present Value (PV) of a Bond When someone buys a bond, they see that the bond will result in a series of interest payments over years, plus an interest payment and the lump sum at the end. To calculate how much the bond is worth, we must calculate its present value (that is, how much is this future stream and lump sum worth today). Present Value of Bond = PV(Interest Payments) + PV(Maturity Amount) Interest payment stream Principal repayment Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Present Value of a Bond PV(Maturity Amount) = Bond Principal x Factor in 17A.1, where: –Bond Principal = the pay value or face value –i = interest rate (quoted as an annual rate) –n = number of payments made over the life of the bond –You can see this in Table 17A.1 on page 865 PV(Interest Payments) = Interest Payment x Factor in 17A.2, where: –Interest Payment = Bond Principal x i/(No. of periods in a year) –i = interest rate (quoted as an annual rate) –n = number of payments made over the life of the bond –You can see this in Table 17A.2 on page 865 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Valuing a Bond Example: What is the value of a $100, year bond, with a coupon rate of 5%, interest paid semi-annually? Let’s say today’s market interest rate is 6%. Present Value of Bond = PV(Coupon Payments) + PV(Maturity Amount) –Coupon Payment = x.05 / 2 = 2500 –PV(Coupon Payments) = 2500 x Factor from 17A.2 where n=40, i=3% = 2500 x (P/A,.06/2, 40) = 2500 x = –PV(Maturity Amount) = x Factor from 17A.1 where n=40, i=3% = x (P/F,.06/2, 40) = x.3066 = –Present Value of the Bond = = Why is a $ only worth $88447? –Because an investor could go to the market and get 6% return, rather than 5%. –This bond is sold at a discount Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Valuing a Bond Example: What is the value of a $100, year bond, with a coupon rate of 5%, interest paid semi-annually? Let’s say today’s market interest rate is 4%. Present Value of Bond = PV(Coupon Payments) + PV(Maturity Amount) –Coupon Payment = x.05 / 2 = 2500 –PV(Coupon Payments) = 2500 x Factor from 17A.2 where n=40, i=2% = 2500 x (P/A,.04/2, 40) = 2500 x = –PV(Maturity Amount) = x Factor from 17A.1 where n=40, i=2% = x (P/F,.04/2, 40) = x.4529 = –Present Value of the Bond = = Why is a $ worth $113678? –Because an investor could by the bond and get 5% return rather than only get 4% in the market. –This bond is sold at a premium Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Psst: Wanna a good stock tip? We can use the same technique to determine the price at which to buy a stock. Scenario: Lets say a your broker calls you up and suggests you should buy a specific stock from him. How do you know it makes sense for you? Scenario: –BCE Inc. is selling at $35.70 per share. It pays a quarterly dividend of $ per share. The current market interest rate is 4%. You plan to hold the stock for 5 years. Should you buy 100 shares of BCE? PV of Stock= PV(Dividend Payments) + PV(Stock price when sold) –If the PV of the stock is greater than its current trading price, we might consider this purchase Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

PV of a Stock When we buy the stock, we would like the stock to be purchased at a price that is less than the present value of the future cash flows of the stock The stock has a few cashflows we should consider –In the future (say 5 years), we may sell the stock. This will represent a cash inflow –The quarterly dividends are a cash inflow –When we buy and sell the stock, we will need to pay brokerage fees, these are cash outflows –When we sell, we will have to pay taxes (a cash outflow) Dividend payment stream Stock sold Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Brokerage fee Taxes Brokerage fee Stock purchase

Valuing a Stock So, again: BCE Inc. is selling at $35.70 per share. It pays a quarterly dividend of $ per share. The current market interest rate is 4%. You plan to hold the stock for 5 years. Should you buy 100 shares of BCE? We know the dividend and its payment schedule so we can figure out its present value We don’t know the price that we will sell the stock at, so we need some additional info to try to forecast the stock price: –BCE’s current P/E ratio: –BCE’s current Earnings per share (EPS): $2.70 PV(Stock price when sold) must be estimated –Stock price (in 5 yrs) = P/E ratio (in 5 yrs) x EPS (in 5 yrs) –We could estimate the P/E ratio that we think the stock will be trading at in 5 years by looking at BCE’s P/E history. Lets just say it will be 13 –Also, we could estimate the EPS. There are many models for this which involve a earnings growth rate, but we can take the current EPS as a conservative estimate –Forecasted stock price = 13 x 2.7 = $35.1 per share Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Valuing a Stock PV of Stock= PV(Dividend Payments) + PV(Stock price when sold) –Dividend Payment = 100 shares x per share = $49.25 per qtr –PV(Dividend Payments) = x Factor from 17A.2 where n=20, i=1% = x (P/A,.04/4, 5 x 4) = x = –PV(Stock price when sold) = 100 shares x 35.1 x Factor from 17A.1 where n=20, i=1% = 3510 x (P/F,.04/4, 5 x 4) = 3510 x.8195 = –Present Value of the Stock= = (or $37.65 per share) Should you buy 100 of BCE? –BCE is currently selling at $35.7. We calculate that the PV of the stock (its intrinsic value) is $ –Though the stock is selling slightly less than its “intrinsic value”, we: Did not factor in brokerage fees on the buy or the sell (they are a small amount if buying 100 shares, but would lower its intrinsic value) We made some assumptions to calculate the selling price of the stock Are not sure if we will sell in 5 years – might be before, might be after Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Valuing a Stock Since we have made some estimates and assumptions, we should use a margin of safety to protect our investment. That is, if we value BCE at $37.1, maybe we need to buy at 10% or 20% below this because we can’t be sure of exactly how long we will hold the stock for or what it will be worth when we sell. Warren Buffet and Ben Graham (world’s most successful value investors) suggest we use a margin of safety of 50%. Do we buy? –Yes, if we don’t use a margin of safety –No, if we take a margin of safety (currently BCE is only trading 4% below its intrinsic value) –The longer we hold the stock, the more dividends we’ll get and so the more safety the dividend provides –Typically, value stocks have EPS which rise over the years. Also, their dividends rise, and so there is some inherent safety because we did not factor these in Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Issuing a Bond at a Discount A Discount on Bonds Payable (a contra-liability on the balance sheet) occurs when a company issues a bond which has a coupon rate below the market rate –Investors will not want this bond as much because they could get a higher rate in the market, so the value of the bond drops. When the company sells the bonds, the transaction looks like this: DateAccount Titles and explanationPRDebitCredit Jan 1Cash88447 Discount on Bonds Payable11553 Bonds Payable Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Issuing a Bond at a Discount The bond is a long term liability and would be shown as below on the balance sheet Balance Sheet Current Assets Cash Current Liabilities AP750 Accounts Receivable2000 Wages1500 Long-term Liabilities Bonds Payable Less: Discount Inventory10000Owner’s Equity22303 Total Assets113000Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Issuing a Bond at a Premium A Premium on Bonds Payable (an accretion-liability on the balance sheet) occurs when a company issues a bond which has a coupon rate higher the market rate –Investors will want to buy this bond up because investing in this bond would yield more than the market could yield. When the company sells the bonds, the transaction looks like this: DateAccount Titles and explanationPRDebitCredit Jan 1Cash Premium on Bonds Payable13687 Bonds Payable Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Issuing a Bond at a Premium Again, the bond is a long term liability and would be shown as below on the balance sheet Balance Sheet Current Assets Cash Current Liabilities AP750 Accounts Receivable2000 Wages1500 Inventory10000Long-term Liabilities Bonds Payable Add: Premium Owner’s Equity22303 Total Assets138240Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Income Statement Regardless of whether the bond is sold at a premium or discount, the company needs to pay interest on its borrowings. –The Bond Interest Expense account is shown against the Revenue for the period –The Bond Interest Expense account reduces the revenue Income Statement Sales Revenue Expenses Bond Interest Expense Net Income Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Amortizing a Discount or Premium In the discount situation, the company will sell a $100,000 but only get $88447 for it. Similarly, in a premium situation, the company will sell a $100,000 but get more than that in cash –It will still need to pay back the full face value of $ in 20 years. –It acknowledges this by amortizing the discount and premium. The payments themselves are still the $2500, but an additional (or reduced) expense is recorded on the income statement to acknowledge the discount There are 2 ways to calculate the amortization: –Straight-line Method –Effective Interest Method For our purposes, we will not get into these details –Just know how to calculate the interest payments and value the bond based on the market rate Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Bond Retirements Bonds can be retired a number of ways –They are paid out by cash at maturity –A company can retire them early by buying them in the open market –Some bonds have a call option on them: allowing them to be purchased at a stated price –Some bonds also have a convertible option, allowing them to be converted to shares, at the request of the bond holder. The details around these calculations will not be covered. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Other Forms of Debt Long-term Notes Payable: These are similar to a bond, but are an agreement between the company and just one lender –Usually these require one repayment with interest Installment Notes: These are an obligation to one lender requiring a series of payments. Interest and some portion of principal is repaid in each payment Mortgage Notes: Similar to a long-term notes payable, except that the note is made with a contract pledging defined assets in the event of default by the borrower on the note. Again, we will not cover the details of these. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Try the Mid-Chapter Demo Problem Check out the mid-chapter demo problem, do parts 1 and 2 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Exercises Do –Exercise 17-1 –Exercise 17-2 –Exercise 17-7 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD