Bonds Payable & Investment in Bonds Module 1 ACG 2071 Created by: Prof. M. Mari

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

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

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

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

Price of Bonds  Depends on –Face amount of the bonds –Periodic interest or coupon rate –Market rate of interest

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

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

Present Value of $1 Table Present value interest factor of $1 per period at i% for n periods, PVIF(i,n). Period5%5.50%6.00%6.50%7%10%11%12%13%14%

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

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). Period5.00%5.50%6.00%6.50%7.00%10.00%11.00%12.00%13.00%14.00%

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

Computing the Price of a Bond  Steps to Compute Price of Bond: 1.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 2.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

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

Computing Price  PV of the Face of Bonds $200,000 X PV( r = 11%/2, Periods = 5yrs X 2) $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. divide interest rate by 2 since interest is paid semiannually then multiply periods by 2 because two payment per year. $200,000 x = $117,086 $200,000 x = $117,086 Found in the present value of $1 table under P = 10 and R = 5.5%

Computing Price of Bond  PV of interest payments $200,000 x 11% $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 = $82,914 Found in the present value of annuity table with p = 10 and r = 5.5%

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.

Bonds Sells above 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 10%. What is price of the bonds

Computing Price  PV of the Face of Bonds $200,000 X PV( r = 10%/2, Periods = 5yrs X 2) $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. divide interest rate by 2 since interest is paid semiannually then multiply periods by 2 because two payment per year. $200,000 x = $122,782 $200,000 x = $122,782 Found in the present value of $1 table under P = 10 and R = 5%

Computing Price of Bond  PV of interest payments $200,000 x 11% $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 = $84,939 Found in the present value of annuity table with p = 10 and r = 5%

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

Bonds Sells below 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 12%. What is price of the bonds

Computing Price  PV of the Face of Bonds $200,000 X PV( r = 12%/2, Periods = 5yrs X 2) $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. divide interest rate by 2 since interest is paid semiannually then multiply periods by 2 because two payment per year. $200,000 x = $111,680 $200,000 x = $111,680 Found in the present value of $1 table under P = 10 and R = 6%

Computing Price of Bond  PV of interest payments $200,000 x 11% $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 = $80,961 Found in the present value of annuity table with p = 10 and r = 6%

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.

Interest rates Recap  If the Market rate = coupon rate –BONDS sells at FACE  If the market rate > Coupon rate –BONDS sells BELOW Face –DISCOUNT  If the market rate < coupon rate –BONDS sells ABOVE face –PREMIUM

Accounting for Bonds  Bonds issued at face value –CashDR  Bonds payableCR  Interest payments are recorded as –Interest expDR  CashCR

Bonds at Discount –Since the price of the bond is below the face value, we must account for the discount incurred. AccountDebit 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.

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

Straight Line Method  Amortization of Discount = Discount on bonds payable Periods Periods = $7,359 = $7, = $ with each interest payment = $ with each interest payment

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 AccountDebitCredit Interest expense$11,736 Discount on bonds payable$736 Cash$11,000 Note that discount increases the interest expense.

Bonds issued at Premium  Since price of bond is above the face value, we must account for premium AccountDebitCredit 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.

Amortization of Bond Premium  Amortization of Premium = Premium on bonds payable Periods Periods = $7,721 = $7, = $772 with each interest payment = $772 with each interest payment

Premium AccountDebitCredit Interest expense$10,228 Premium on bond payable$772 Cash$11,000 Premium amortization decreases interest expense.

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

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

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

Bond Redemption  Example: Bonds with a face of $100,000, and unamortized premium of $5,000 are redeemed for $102,000. AccountDebitCredit Bonds payable$100,000 Premium on bond payable$5,000 Cash$102,000 Gain on redemption of bonds$3,000

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. AccountDebitCredit Bonds payable$100,000 Loss on redemption of bonds$2,000 Discount on bonds payable$4,000 Cash$98,000

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.

Investments in Bonds  Example: Suppose that we purchase a $10,000 bond at 101 plus commission of $60 and accrued interest of $ Record the purchase. AccountDebitCredit Investment in bonds$10,060 Interest revenue$105 Cash$10,165