Bonds Payable & Investment in Bonds

Bonds Payable & Investment in Bonds By Rachelle Agatha, CPA, MBA Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

0 Objectives: Compute the potential impact of long-term borrowing on earnings per share. Describe the characteristics, terminology, and pricing of bonds payable. Journalize entries for bonds payable.

0 Objectives: Describe and illustrate the payment and redemption of bonds payable. Journalize entries for the purchase, interest, discount and premium amortization, and sale of bond investments. Prepare a corporation balance sheet.

0 Objective 1 Compute the potential impact of long-term borrowing on the earnings per share of a corporation.

0 Financing Corporations A bond is simply a form of an interest-bearing note. Like a note, a bond requires periodic interest payments, and the face amount must be repaid at the maturity date.

0 Plan 1Plan 2Plan 3 Issued 12% bonds $4 million $2 million $2 million Issued 9% preferred stock, $50 par value $2 million $1 million Issued common stock, $10 par value $1 million $4 million $4 million $4 million

0 Effect of Alternative Financing Plans—$800,000 Earnings

0 Effect of Alternative Financing Plans—$440,000 Earnings 8

0 Gonzales Co., is considering the following alternative plans for financing their company: Plan I Plan II Issue 10% Bonds (at face) $2,000,000 Issue $10 Common Stock $3,000,000 $1,000,000 Income tax is estimated at 40% of income. Determine the earnings per share of common stock under the two alternative financing plans, assuming income before bond interest and income tax is $750,000.

Plan I Plan II $750,000 0 $750,000 300,000 $450,000 0 $450,000 /300,000 $750,000 200,000 $550,000 220,000 $330,000 0 $330,000 /100,000 (2,000,000 x 10%) ($750,000 x 40%) ($550,000 x 40%) $1.50 $3.30 0 Earnings before bond interest and income tax Bond interest Balance Income tax Net income Dividend on preferred stock Earnings available for common stock Number of common shares Earnings per share on common stock

0 Objective 2 Describe the characteristics, terminology, and pricing of bonds payable.

0 Bonds Payable • A corporation that issues bonds enters into a contract (called a bond indentureortrust indenture) with the bondholders. • Usually, the face value of each bond, called the principal, is $1,000 or a multiple of $1,000. • Interest on bonds may be payable annually, semiannually, or quarterly. Most pay interest semiannually.

0 • When all bonds of an issue mature at the same time, they are called term bonds. • If the maturity dates are spread over several dates, they are called serial bonds. • Bonds that may be exchanged for other securities are called convertible bonds.

0 • Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds. • Bonds issued on the basis of the general credit of the corporation are debenturebonds.

0 Pricing of Bonds Payable When a corporation issues bonds, the price that buyers are willing to pay depends upon three factors: 1. The face amount of the bonds, which is the amount due at the maturity date. 2. The periodic interest to be paid on the bonds. This is called the contract rateor thecoupon rate. 3. Themarket or effective rate of interest.

0 The market or effective rate of interest is determined by transactions between buyers and sellers of similar bonds. The market rate of interest is affected by a variety of factors, including: • investors assessment of current economic conditions, and • future expectations.

0 MARKET RATE = CONTRACT RATE Selling price of bond = $1,000 $1,000 10% payable annually If the contract rate equals the market rate of interest, the bonds will sell at their face amount.

$1,000 10% payable annually Discount 0 MARKET RATE > CONTRACT RATE Selling price of bond < $1,000 – If the market rate is higher than the contract rate, the bonds will sell at a discount.

$1,000 10% payable annually Premium 0 MARKET < CONTRACT RATE Selling price of bond > $1,000 + If the market rate is lower than the contract rate, the bonds will sell at a premium.

0 Time Value of Money The time value of money concept recognizes that an amount of cash to be received today is worth more than the same amount of cash to be received in the future.

End of Year 1 End of Year 2 Today $1,000 10% payable annually 0 Present Value of the Face Amount of Bonds A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

Present Value of $1 at Compound Interest N = 2 rate =10%

End of Year 1 End of Year 2 Today $1,000 10% payable annually $1,000 x 0.82645 $826.45 0 Present Value of the Face Amount of Bonds A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

0 Using Exhibit 3 in your test, what is the present value of $4,000 to be received in 5 years, if the market rate of interest is 10% compounded annually? $4,000 x .62092* = $2,483.68 *Present value of $1 for 5 periods at 10%

$100 $100 Interest payment Interest payment End of Year 1 End of Year 2 Today $90.91 $100 x 0.90909 $100 x 0.82645 $82.64 Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded) $173.55 0 Present Value of the Periodic Bond Interest Payments

Present Value of Annuity of $1 at Compound Interest

Present value of face value of $1,000 due in 2 years at 10% compounded annually: $1,000 x 0.82645 (Exhibit 3: n = 2, i = 10%) $ 826.45 Present value of 2 annual interest payments of 10% compounded annually: $100 x 1.73554 (Exhibit 4: n = 2, i = 10%) 173.55 Total present value of bond $1,000.00 0 Present Value of 2-Year, 10% Bond

0 Calculate the present value of a $20,000, 5%, 5-year bond that pays $1,000 ($20,000 x 5%) interest annually, if the market rate of interest is 5%. Use Exhibits 3 and 4 for computing present values.

$20,000 0 Present value of face value of $20,000 due in 5 years at 5% compounded annually: $20,000 x .78353 (present value factor of $1 for 5 periods at 5%) $15,671* Present value of 5 annual interest payments of $1,000 at 5% interest compounded annually: $1,000 x 4.32948 (present value of annuity of $1 for 5 periods at 5%). 4,329* *Rounded to the nearest dollar

0 Objective 3 Journalize entries for bonds payable.

0 Bonds Issued at Face Amount On January 1, 2007, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%.

Present value of face amount of $100,000 due in 5 years at 12% compounded annually: $100,000 x 0.55840 (Exhibit 3: n = 10, i = 6%) $ 55,840 Present value of 10 interest payments of $6,000 at 12% compounded semiannually: $6,000 x 7.36009 (Exhibit 4: n = 10; i = 6%) 44,160* Total present value of bonds $100,000 0 *Because the present value tables are rounded to five decimal places, minor rounding differences may appear in this illustration.

2007 Jan. 1 Cash 100 000 00 0 On January 1, 2007, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannual. The market rate of interest is 12%. Bonds Payable 100 000 00 Issued $100,000 bonds payable at face amount.

0 On June 30, an interest payment of $6,000 is made ($100,000 x .12 x 6/12). June 30 Interest Expense 6 000 00 Cash 6 000 00 Paid six months’ interest on bonds.

2011 Dec. 31 Bonds Payable 100 000 00 0 The bond matured on December 31, 2011. At this time, the corporation paid the face amount to the bondholder. Cash 100 000 00 Paid bond principal at maturity date.

0 Bonds Issued at a Discount Assume that the market rate of interest is 13% on the $100,000 bonds rather than 12%. What would be the present value of these bonds?

Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273 $53,273 Present value of 10 interest payments of $6,000, at 13% compounded semiannually: $6,000 x 7.18883 (present value of annuity of $1 for 10 periods at 6%) 43,133 Total present value of bonds $96,406 0

2007 Jan. 1 Cash 96 406 00 0 On January 1, 2007, the firm issued $100,000 bonds for $96,406 (a discount of $3,594). Discount on Bonds Payable 3 594 00 Bonds Payable 100 000 00 Issued $100,000 bonds at discount.

0 On the first day of the fiscal year, a company issues a $1,000,000, 6%, 5-year bond that pays semi-annual interest of $30,000 ($1,000,000 x 6% x ½), receiving cash of $845,562. Journalize the entry to record the issuance of the bonds. Cash 845,562 Discount on Bonds Payable 154,438 Bonds Payable 1,000,000

0 Amortizing a Bond Discount There are two methods of amortizing a bond discount: • The straight-line method and • The effective interest rate method, often called the interest method. Both methods amortize the same total amount of discount over the life of the bonds.

2007 June 30 Interest Expense 6 359 40 0 Amortizing a Bond Discount On June 30, 2007, six-months’ interest is paid and the bond discount is amortized ($3,594 x 1/10) using the straight-line method. Discount on Bonds Payable 359 40 Cash 6 000 00 Paid semiannual interest and amortized 1/10 of bond discount.

Interest Expense 45,444 Discount on Bonds Payable 15,444 Cash 30,000 Paid interest and amortized the bond discount ($154,438 ÷ 10). 0

0 Bonds Issued at a Premium If the market rate of interest is 11% and the contract rate is 12%, on the five year, $100,000 bonds, the bonds will sell for $103,769.

Present value of face amount of $100,000 due in 5 years at 11% compounded semiannually: $100,000 x 0.58543 (Exhibit 3: n =10, i = 5½%) $ 58,543 Present value of 10 interest payments of $6,000, at 11% compounded semiannually: $6,000 x 7.53763 (Exhibit 4: n = 10, i = 5½%) 45,226 Total present value of bonds $103,769 0

2007 Jan. 1 Cash 103 769 00 0 Issued $100,000 of bonds for $103,769 (a premium of $3,769). The entry to record this information is as follows: Bonds Payable 100 000 00 Premium on Bonds Payable 3 769 00 Issued $100,000 bonds at a premium.

0 A company issues a $2,000,000, 12%, 5-year bond that pays semiannual interest of $120,000 ($2,000,000 x 12% x ½), receiving cash of $2,154,435. Journalize the bond issuance. Cash 2,154,435 Premium on Bonds Payable 154,438 Bonds Payable 2,000,000

2007 June 30 Interest Expense 5 623 10 0 Amortizing a Bond Premium On June 30, 2007, paid the semiannual interest and amortized the premium. The firm uses straight-line amortization. Premium on Bonds Payable 376 90 Cash 6 000 00 Paid semiannual interest and amortized 1/10 of bond prem. $3,769 x 1/10

0 Using the bond from previous example, journalize the first interest payment and the amortization of the related bond premium. Interest Expense 104,556 Premium on Bonds Payable 15,444 Bonds Payable 120,000 Paid interest and amortize the bond premium ($154,435/10).

0 Zero-Coupon Bonds Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity. Assume that the market rate is 13% at date of issue. Present value of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273 (PV of $1 for 10 periods at 6½%) = $53,273

2007 Jan. 1 Cash 53 273 00 Discount on Bonds Payable 46 727 00 0 On January 1, 2007, issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%. Bonds Payable 100 000 00 Issued $100,000 zero-coupon bonds.

Bonds Payable & Investment in Bonds