© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Chapter 10 Reporting and Interpreting Bonds

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Significant debt needs of a company are often filled by issuing bonds. Business Background Capital Structure - Bonds BondsCash

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Business Background liquidity Bonds can be traded on established exchanges that provide liquidity to bondholders. As liquidity increases Cost of borrowing decreases.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Business Background Advantages of bonds: Bonds are debt, not equity, so the ownership and control of the company are not diluted. Interest expense is tax-deductible. The low interest rates on bonds allow for positive financial leverage. Advantages of bonds: Bonds are debt, not equity, so the ownership and control of the company are not diluted. Interest expense is tax-deductible. The low interest rates on bonds allow for positive financial leverage.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Business Background Disadvantages of bonds: The scheduled interest payments are legal obligations and must be paid each period. A single, large principal payment is required at the maturity date. Disadvantages of bonds: The scheduled interest payments are legal obligations and must be paid each period. A single, large principal payment is required at the maturity date.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Key Ratio Analysis The debt-equity ratio is an important measure of the balance between debt and equity. High debt-equity ratios(Greater than 1 to 1) indicate more leverage and risk.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill 1. Face Value = Maturity or Par Value, Principal 2. Maturity Date 3. Stated Interest Rate 4. Interest Payment Dates 5. Bond Date Characteristics of Bonds Payable Other Factors: 6. Market Interest Rate 7. Issue Date BOND PAYABLE Face Value $1,000 Interest 10% 6/30 & 12/31 Maturity Date 1/1/10Bond Date 1/1/01

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Senior DebtSenior Debt receives preference over other creditors in the event of bankruptcy or default. Subordinated DebtSubordinated Debt is riskier than senior debt. Senior DebtSenior Debt receives preference over other creditors in the event of bankruptcy or default. Subordinated DebtSubordinated Debt is riskier than senior debt. Bond Classifications

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Measuring Bonds Payable and Interest Expense The issue price of the bond is determined by the market, based on the time value of money. market interest rate The interest rate used to compute the present value is the market interest rate.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Measuring Bonds Payable and Interest Expense stated rate The stated rate is only used to compute the periodic interest payments.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Bond Premium and Discounts (See-Saw Diagram) = > < > < =

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually. Are Harrah’s bonds issued at par, at a discount, or at a premium?

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually. Issuing Bonds <<

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually. Compute the issue price of Harrah’s bonds.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ÊCompute the present value of the principal. Use the present value of a single amount table to find the appropriate factor.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ÊCompute the present value of the principal. Use the market rate of 8% to determine present value. Interest is paid semiannually, so the rate is i=4% (8% ÷ 2 interest periods per year).

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ÊCompute the present value of the principal. Though the maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20 (10 years × 2 periods per year).

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ÊCompute the present value of the principal.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ËCompute the present value of the interest payments. The interest payment is computed as: $1,000,000 × 6% × 6/12 = $30,000 The interest payment is computed as: $1,000,000 × 6% × 6/12 = $30,000

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ËCompute the present value of the interest payments. Use the same i=4.0% and n=20 used for the present value of the principal, but use the present value of an annuity table.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ËCompute the present value of the interest payments. Now, the issue price of the bonds can be computed.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ÌCompute the issue price of the bonds.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds ÌCompute the issue price of the bonds. The $864,109 is less than the face amount of $1,000,000, so the bonds are issued at a discount of $135,891.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Recording Bonds Issued at a Discount ÍPrepare the journal entry to record the issuance of the bonds. This is a contra-liability account and appears in the liability section of the balance sheet.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Bonds Issued at a Discount Financial Statement Presentation The discount will be amortized over the 10- year life of the bonds.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Straight-Line Amortization of Bond Discount Ê Identify the amount of the bond discount. Ë Divide the bond discount by the number of interest periods. Ì Include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date. Ê Identify the amount of the bond discount. Ë Divide the bond discount by the number of interest periods. Ì Include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Straight-Line Amortization of Bond Discount Harrah’s issued their bonds on May 1, The discount was $135,891. The bonds have a 10-year maturity and $30,000 interest is paid semiannually. Compute the periodic discount amortization using the straight-line method.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Harrah’s issued their bonds on May 1, The discount was $135,891. The bonds have a 10-year maturity and $30,000 interest is paid semiannually. Compute the periodic discount amortization using the straight-line method. Straight-Line Amortization of Bond Discount

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Straight-Line Amortization of Bond Discount Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on November 1, 2001.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Bonds Issued at a Discount Financial Statement Presentation As the discount is amortized, the carrying amount of the bonds increases.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Zero Coupon Bonds Zero coupon bonds do not pay periodic interest. Because there is no interest annuity... deep discount bondThis is called a deep discount bond. Discount is amortized using straight line method PV of the Principal = Issue Price of the Bonds

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium = > < > < =

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually. Are Harrah’s bonds issued at par, at a discount, or at a premium?

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8% annually. Issuing Bonds at a Premium >> Let’s compute the issue price of the bonds.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ÊCompute the present value of the principal. Use the present value of a single amount table to find the appropriate factor.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ÊCompute the present value of the principal. Use the market rate of 8% to determine present value. Interest is paid semiannually, so the rate is i=4.0% (8% ÷ 2 interest periods per year).

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ÊCompute the present value of the principal. The maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20 (10 years × 2 periods).

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ÊCompute the present value of the principal. Next, we compute the present value of the interest payments.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ËCompute the present value of the interest payments. The interest payment is computed as: $1,000,000 × 10% × 6/12 = $50,000 The interest payment is computed as: $1,000,000 × 10% × 6/12 = $50,000

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ËCompute the present value of the interest payments. Use the same i=4.0% and n=20 that were used to compute the present value of the principal. Now, however, the factor comes from the present value of an annuity table.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ËCompute the present value of the interest payments. Now, the issue price of the bonds can be computed.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ÌCompute the issue price of the bonds. The $1,135,915 is greater than the face amount of $1,000,000, so the bonds are issued at a premium of $135,915.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Issuing Bonds at a Premium ÍPrepare the journal entry to record the issuance of the bonds. This is called an adjunct account and appears in the liability section.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Bonds Issued at a Premium Financial Statement Presentation The premium will be amortized over the 10- year life of the bonds.

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill Recording Interest Expense Amortization of Bond Preemium: $135,915 / 20 = $6, Recording Interest Expense: Bond Interest Expense $43,204 Premium on Bonds 6,796 Cash 50,000

© The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill End of Chapter 10