1. 1 © Copyrright Doug Hillman 2000 Long-term Liabilities

2. 2 © Copyrright Doug Hillman 2000 Bonds l Written promise to pay a specific sum of money on a speciific future date l Purchaser is bondholder l Receives Bond certificate

3. 3 © Copyrright Doug Hillman 2000 Classification of Bonds l Registered - issued in name of holder l Secured - assets pledged as security l Debenture (unsecured) - based on general credit l Serial - mature in installments l Callable - corporation has option of retiring

4. 4 © Copyrright Doug Hillman 2000 Bonds Compared to Stock l Bondholders are creditors l Bonds a liability l Interest is fixed charge l Interest is expense l Interest tax deductible l No voting l Stockholders are owners l Stock is equity l Dividends not fixed charges l Dividends not expense l Dividends not tax deductible l Voting

5. 5 © Copyrright Doug Hillman 2000 Financial Leverage l Borrowed money invested within business to earn a higher rate than borrowing cost l When positive financial leverage occurs, use of bonds will produce higher EPS than financing same investment with stock l Use of bonds will also produce higher amount available for reinvestment

6. 6 © Copyrright Doug Hillman 2000 Bond Terms l Face value ›The principal of the bond payable at maturity l Stated interest rate ›The rate multiplied by face value to get periodic cash interest payment l Term ›Time to maturity

7. 7 © Copyrright Doug Hillman 2000 Why Bonds Sell at Discount or Premium l When market interest rate on comparable grade bonds is higher or lower than the stated rate,

8. 8 © Copyrright Doug Hillman 2000 Why Bonds Sell at Discount or Premium l When market interest rate on comparable grade bonds is higher or lower than the stated rate, investors will adjust the purchase price of the bond so that they earn the desired market interest rate

9. 9 © Copyrright Doug Hillman 2000 Why Bonds Sell at Discount or Premium l Why Bonds Sell at Discount or PremiumWhen market interest rate on comparable grade bonds is higher or lower than the stated rate, investors will adjust the purchase price of the bond so that they earn the desired market interest rate l Issuing price determines effective or yield rate

10. 10 © Copyrright Doug Hillman 2000 Why Bonds Sell at Discount or Premium l If the market rate is higher than stated rate, investors will offer less than face value l Difference between price paid and face value is discount l Effective interest rate is higher than stated interest rate

11. 11 © Copyrright Doug Hillman 2000 Why Bonds Sell at Discount or Premium l If market rate is lower than stated rate, investors will offer more than face value l Difference between price paid and face value is premium l Effective interest rate is lower than stated interest rate

12. 12 © Copyrright Doug Hillman 2000 Sales Price of Bond l Bond promises two future cash flows ›Periodic interest payments ›Principal at maturity l Price of bond today is the sum of the present value of these two future cash flows discounted at the interest rate the investor desires to earn (market rate)

13. 13 © Copyrright Doug Hillman 2000 Calculation of Bond Price l Assume $100,000, 10%, 10 year bond, interest payable semiannually on 6/30 and 12/31, market interest rate 12% l Since the market interest rate (12%) is higher than the stated interest rate (10%), the bond should sell at a discount

14. 14 © Copyrright Doug Hillman 2000 Calculation of Bond Price l PV of face amount (i=6%,n=20) ›$100,000 x 0.312 = $31,200 l PV of interest payments ›$5,000 x 11.470 = $57,350 l Price of bond = $88,550

15. 15 © Copyrright Doug Hillman 2000 Issuance of Bonds l Increase Cash for the proceeds of issuance l Increase Bonds Payable for face value l Increase Premium or Discount for the difference

16. 16 © Copyrright Doug Hillman 2000 Amortization of Premium or Discount l The premium or discount is an adjustment to the interest l To record the proper interest expense, we must amortize the premium or discount l Two methods ›Straight-line - constant amortization ›Effective interest - constant effective rate

17. 17 © Copyrright Doug Hillman 2000 Recording Interest Straight-Line l Decrease Cash for ›Face amount x Stated rate X Time l Decrease Premium or Discount for ›Premium or Discount / Time to maturity l Increase Interest Expense for ›Sum of cash and amortization

18. 18 © Copyrright Doug Hillman 2000 Recording Interest Effective Interest Method l Decrease Cash for ›Face amount x Stated Rate x Time l Increase Interest Expense for ›Carrying value x Effective Interest Rate x Time l Decrease Premium or Discount for ›The difference between cash and interest expense

19. 19 © Copyrright Doug Hillman 2000 Discount Amortization Example l $10,000, 10%, 2 year bond l Interest payable semiannually l Market interest rate 11% l Issue price $9,822.50

20. 20 © Copyrright Doug Hillman 2000 Discount Amortization Straight-Line PdCash Exp AmortCV 09,822.50 1500.00544.3844.389,866.88 2500.00544.3844.389,911.26 3500.00544.3844.389,955.64 4500.00544.3844.3610,000.00

21. 21 © Copyrright Doug Hillman 2000 Proof of Interest Future cash payments Face$10,000.00 Interest2,000.00 Total$12,000.00 Cash received9,822.50 Total interest$2,177.50 Semiannual interest $2,177.50 / 4 = $544.38

22. 22 © Copyrright Doug Hillman 2000 Discount Amortization Effective Interest PdCash Exp AmortCV 09,822.50 1500.00540.2440.249,862.74 2500.00542.4542.459,905.19 3500.00544.7944.799,949.98 4500.00547.2547.25*9,997.23 *rounding error

23. 23 © Copyrright Doug Hillman 2000 Premium Amortization Example l $10,000, 10%, 2 year bond l Interest payable semiannually l Market interest rate 9% l Issue price $10,184.00

24. 24 © Copyrright Doug Hillman 2000 Premium Amortization Straight-Line PdCash Exp AmortCV 010,184.00 1500.00454.0046.0010,138.00 2500.00 454.0046.0010,092.00 3500.00 454.0046.0010,046.00 4500.00 454.0046.0010,000.00

25. 25 © Copyrright Doug Hillman 2000 Proof of Interest Future cash payments Face$10,000.00 Interest2,000.00 Total$12,000.00 Cash received10,184.00 Total interest$1,816.00 Semiannual interest $1,816.00 / 4 = $454.00

26. 26 © Copyrright Doug Hillman 2000 Premium Amortization Effective Interest PdCash Exp AmortCV 010,184.00 1500.00458.2841.7210,142.28 2500.00 456.4043.6010,098.68 3500.00 454.4445.5610,053.12 4500.00 452.3947.61*10,005.51 *rounding error

27. 27 © Copyrright Doug Hillman 2000 Issuance Between Interest Dates l Interest since last interest payment date accrues to date of issuance at the stated rate l Proceeds of issuance include ›Market price of bond ›Accrued interest –Accrued interest increases Interest Payable

28. 28 © Copyrright Doug Hillman 2000 Issuance Between Interest Dates l Next interest payment is for full 6 months and pays off Interest Payabe l Resulting interest expense is only for period since issuance

29. 29 © Copyrright Doug Hillman 2000 Mortgage Notes Payable l Long-term note with assignment of an interest in property l Mortgage paid in equal periodic installments l Each payment includes ›Interest at specified rate on unpaid principal ›Reduction of principal for difference between payment and interest

30. 30 © Copyrright Doug Hillman 2000 Analyzing Information l Is the level of total debt manageable? l Does it seem likely interest and principal payments can be met? ›Times Interest Earned ratio ›Debit ratio l If firm needs additional financing, would you recommend lending or investing in it?