learning objectives

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Learning Objectives

Power Notes

1. Financing Corporations2. Characteristics of Bonds Payable3. The Present-Value Concept and Bonds Payable4. Accounting for Bonds Payable5. Bond Sinking Funds6. Bond Redemption7. Investments in Bonds8. Corporation Balance Sheet9. Financial Analysis and Interpretation

Chapter F13

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Bonds Payable and Investments in Bonds Bonds Payable and Investments in Bonds

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• Long-Term Financing• Characteristics of Bonds Payable• Time Value of Money• Issuing Bonds Payable• Redemption of Bonds Payable• Investments in Bonds• Number of Times Interest Earned

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Power NotesChapter F13


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Two Methods of Long-Term FinancingTwo Methods of Long-Term Financing

Resources = Sources

Stockholders’Equity

Assets

Liabilities

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Resources = Sources


Assets

Liabilities

Equity Financing – Stockholders

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Resources = Sources


Assets

Liabilities

Bondholders

Equity Financing – Stockholders

Debt Financing – Bondholders

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Two Methods of FinancingTwo Methods of Financing

Bondholders

Bonds (debt)Bonds (debt) – Interest payments to bondholders are an expense that reduces taxable income.

Stock (equity)Stock (equity) – Dividend payments are made from after tax net income and retained earnings. Earnings per share on common stock can often be increased by issuing bonds rather than additional stock.

Why issue bonds rather than stock?Why issue bonds rather than stock?

Stockholders

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Alternative Financing Plans – $800,000 EarningsAlternative Financing Plans – $800,000 Earnings

Plan 1 Plan 2 Plan 312 % bonds — — $2,000,000Preferred 9% stock, $50 par — $2,000,000 1,000,000Common stock, $10 par $4,000,000 2,000,000 1,000,000Total $4,000,000 $4,000,000 $4,000,000Earnings before interest

and income tax $ 800,000 $ 800,000 $ 800,000Deduct interest on bonds — — 240,000Income before income tax $ 800,000 $ 800,000 $ 560,000Deduct income tax 320,000 320,000 224,000Net income $ 480,000 $ 480,000 $ 336,000Dividends on preferred stock — 180,000 90,000Available for dividends $ 480,000 $ 300,000 $ 246,000

Shares of common stock 400,000 200,000 100,000

Earnings per share $ 1.20 $ 1.50 $ 2.46

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Alternative Financing Plans – $440,000 EarningsAlternative Financing Plans – $440,000 Earnings

Plan 1 Plan 2 Plan 312 % bonds — — $2,000,000Preferred 9% stock, $50 par — $2,000,000 1,000,000Common stock, $10 par $4,000,000 2,000,000 1,000,000Total $4,000,000 $4,000,000 $4,000,000Earnings before interest

and income tax $ 440,000 $ 440,000 $ 440,000Deduct interest on bonds — — 240,000Income before income tax $ 440,000 $ 440,000 $ 200,000Deduct income tax 176,000 176,000 80,000Net income $ 264,000 $ 264,000 $ 120,000Dividends on preferred stock — 180,000 90,000Available for dividends $ 264,000 $ 84,000 $ 30,000

Shares of common stock 400,000 200,000 100,000

Earnings per share $ 0.66 $ 0.42 $ 0.30

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Characteristics of Bonds PayableCharacteristics of Bonds Payable

Long-term debt – repayable 10, 20, or 30 years after date of issuance.

Issued in face (principal) amounts of $1,000, or multiples of $1,000.

Contract interest rate is fixed for term (life) of the bond.

Face amount of bond repayable at maturity date.

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Bond Variables and ConstantsBond Variables and Constants

1. ConstantsConstants – fixed by bond contract.a. Principal (face) amount.b. Contract rate of interest.c. Term (life) of the bond.

2. VariablesVariables – determined in the bond market.a. Market price of the bond.b. Market (effective) interest rate.

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How are Bond Prices DeterminedHow are Bond Prices Determined

1. Present Value of Face Amount

The present value of the face amount (constant) of the bond at its maturity date, based on the current market interest rate (variable).

2. Present Value of Interest Payments

The present value of the periodic interest payments (constant) for the term of the bonds, based on the current market interest rate (variable).

The selling price of bonds are based on two amounts.

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Market and Contract Interest RatesMarket and Contract Interest Rates

Differences in market and bond contract interest rates result in Discounts and Premiums.

When Bonds sell at

Market rate = Contract rate

Market rate > Contract rate

Market rate < Contract rate

Face value

Discount

Premium

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Cash Flow of Bonds PayableCash Flow of Bonds Payable

Cash Outflows:Interest payments $ 60,000 = $ 43,133 (10 periods at $6,000)Face amount 100,000 = 53,273 (at end of 5 years)

$160,000 = $96,403Cash Inflows:Selling proceeds $ 96,406 = $96,406

Present Values

On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 13% at date of issue.

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Present Values


Present value of an annuity of $6,000 for 10 periods at a market rate of 6.5% per period is $43,133.

Payment x Factor = Present Value

$6,000 x 7.1888 = $43,133

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Present Values


Present value of $100,000 paid at the end of 10 six-month periods at a market rate of 6.5% per period is $53,273.

Payment x Factor = Present Value

$100,000 x .53273 = $53,273

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Present Values



$160,000$160,000 = $96,406Cash Inflows:Selling price $96,406$96,406

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The Time Value of Money – Future ValueThe Time Value of Money – Future Value

The time value of money concept is used in many business decisions. This concept is an important consideration in accounting for bonds payable.

PresentValue

FutureValue

$1,000

$ ????

What is the future value of $1,000 invested today (present value) at 8% per year?


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The Time Value of Money – Future ValueThe Time Value of Money – Future Value


PresentValue

FutureValue

$1,000

= $1,000 + ($1,000 x 8%)= $1,000 x 108% or 1.08



$1,080

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The Time Value of Money – Present ValueThe Time Value of Money – Present Value


PresentValue

FutureValue

$ ????

What is the present value of $1,000 to be received one year from today at 8% per year?


$1,000

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The Time Value of Money – Present ValueThe Time Value of Money – Present Value


PresentValue

FutureValue

$ 925.93 = $1,000 / 108% or 1.08



$1,000

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Calculating Present ValuesCalculating Present Values

Present values can be determined using present value tables, mathematical formulas, calculators or computers.

Present value of $1 with Compound Interest

1 .9434 = $1.0000 / 1.06

CalculatorPV Table

Period 6%

One dollar at the end of one period at 6% per period is equal to $.9434 today (present value).

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PV Table

Period 6%

One dollar at the end of two periods at 6% per period is equal to $.8900 today (present value).

To use the value from the prior period as the starting point, don’t clear your calculator.

1 .9434.9434 = $1.0000 / 1.06

2 .8900 = $$ .9434.9434 / 1.06

Calculator

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Present values can be determined using present value tables, mathematical formulas, calculators, or computers.


PV Table

Period 6%

One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value).

1 .9434 = $1.0000 / 1.06

2 .8900.8900 = $ .9434 / 1.06

3 .8396 = $ .8900$ .8900 / 1.06

Calculator

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1 .9434 = $1.0000 / 1.06

2 .8900 = $ .9434 / 1.06

3 .8396 = $ .8900 / 1.06

4 .7921 = $ .8396 / 1.06

5 .7432 = $ .7921 / 1.06

6 .7050 = $ .7432 / 1.06

PV Table

Period 6%

When using a calculator, learn to use constant division. You will then enter $1 and 1.06 the first time, pressing only the equal (=) key for each successive answer.

Calculator

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Calculating Present Values of AnnuitiesCalculating Present Values of Annuities

Present value of $1 — Annuity of $1

PV Table Annuity

Period 6% 6%

CalculationSum of Periods

1 .9434.9434 .9434 = Period 1

2 .8900.8900 1.8334 = Periods 1–2

3 .8396 2.6730 = Periods 1–3

4 .7921 3.4651 = Periods 1–4

5 .7432 4.2124 = Periods 1–5

4.2124

The PV of an annuity of $1 to be received each year for two years is $1.8334. This is the sum of the PV of the two amounts for periods 1 and 2.

Annuities represent a series of equal amounts to be paid or received in the future over equal periods.

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Present value of $1 — Annuity of 1$

PV Table Annuity

Period 6% 6%


1 .9434.9434 .9434 = Period 1

2 .8900.8900 1.8334 = Periods 1–2

3 .8396.8396 2.6730 = Periods 1–3

4 .7921 3.4651 = Periods 1–4

5 .7432 4.2124 = Periods 1–5

4.2124

The PV of an annuity of $1 to be received each year for three years is $2.6730. This is the sum of the PV of the three amounts for periods 1–3.


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Present value of $1 — Annuity of 1$

PV Table Annuity

Period 6% 6%


1 .9434 .9434 = Period 1

2 .8900 1.8334 = Periods 1–2

3 .8396 2.6730 = Periods 1–3

4 .7921 3.4651 = Periods 1–4

5 .7473 4.2124 = Periods 1–5

4.2124Total

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Cash 100,000Bonds Payable 100,000

PV of face due in 5 years ($100,000 x 0.55840) = $55,840 PV of $1 for 10 periods at 6%

PV of 10 interest payments ($6,000 x 7.36009) = 44,160 PV of annuity of $1 for 10 periods at 6%

Total selling price = $100,000

DateDate DescriptionDescription DebitDebit CreditCredit

Bonds Issued at Face AmountBonds Issued at Face Amount

Jan. 1

Issued 12%, five-year bonds at face.


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Bonds Issued at a DiscountBonds Issued at a Discount

Cash 96,406Discount on Bonds Payable 3,594

Bonds Payable 100,000

PV of face due in 5 years ($100,000 x 0.53273) = $53,273 (PV of $1 for 10 periods at 6.5%)

PV of 10 interest payments ($6,000 x 7.18883) = $43,133 (PV of annuity of $1 for 10 periods at 6.5%)

Total selling price = $96,406

Jan. 1

Issued 12%, five-year bonds at a discount.


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Amortization of a Bond DiscountAmortization of a Bond Discount

Interest Expense 6,359.70Discount on Bonds Payable 359.70Cash 6,000.00

Jan. 1

Issued 12%, five-year bonds at a discount.

The straight-line method amortizes bond discount in equal periodic amounts.



Payment of semiannual interest andamortization of 1/10 of bond discount.

Jun. 30

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Bonds Issued at a PremiumBonds Issued at a Premium

Cash 103,769 Bonds Payable 100,000

Premium on Bonds Payable 3,769

PV of face due in 5 years ($100,000 x 0.58543) = $ 58,543 (PV of $1 for 10 periods at 5.5%)

PV of 10 interest payments ($6,000 x 7.53763) = 45,226 (PV of annuity of $1 for 10 periods at 5.5%)

Total PV (selling price) = $103,769

Jan. 1

Issued 12%, five-year bonds at a premium.


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Amortization of a Bond PremiumAmortization of a Bond Premium

Interest Expense 5,623.10Premium on Bonds Payable 376.90

Cash 6,000.00

Jan. 1

Issued 12%, five-year bonds at a premium.

The straight-line method amortizes bond premium in equal periodic amounts.

Cash 103,769 Bonds Payable 100,000

Premium on Bonds Payable 3,769

Payment of semiannual interest andamortization of 1/10 of bond premium.

Jun. 30

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Zero-Coupon BondsZero-Coupon Bonds



PV of face due in 5 years ($100,000 x 0.53273) = $53,273 (PV of $1 for 10 periods at 6.5%)

An investment of $53,273 today would yield $100,000 in five years compounded semiannually at 6.5%.

Jan. 1

Issued $100,000 five-year zero-coupon bonds.

Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity. Assume market rate is 13% at date of issue.

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Bond RedemptionBond Redemption

Bonds Payable 25,000Premium on Bonds Payable 1,000

Gain on Redemption of Bonds 2,000Cash 24,000

Redeemed one-fourth of the total bonds.

A corporation may call or redeem its bonds before they mature. Assume a bond issue of $100,000 and an unamortized premium of $4,000. Carrying value is $96,000 and one-fourth of the bonds are purchased.

Jun. 30

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Investments in BondsInvestments in Bonds

Investment in Bonds 1,025.30Interest Revenue 10.20

Cash 1,035.50

Investors do not usually record premium (or discount) in separate accounts because bonds are not often held until maturity.

Purchased a $1,000 bond at 102 plus a brokerage fee of $5.30 and accrued interest of $10.20

Bonds are purchased directly from the issuing corporation or through an organized bond exchange. Bond prices are quoted as a percentage of the face amount.

Apr. 2

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Solvency Measures — The Long-Term CreditorSolvency Measures — The Long-Term Creditor

Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

2003 2002

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000

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Solvency Measures — The Long-Term CreditorSolvency Measures — The Long-Term Creditor

Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

2003 2002

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000

Number of times earnedNumber of times earned 4.0 times4.0 times 4.2 times4.2 times

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This is the last slide in Chapter F13. This is the last slide in Chapter F13.

Power NotesChapter F13


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