Chapter 10: Bonds Flashcards
Advantages of Bonds
- Shareholders maintain control
- Cash payments to debt holders are limited to the scheduled payments of interest and principal
- Interest expense is tax deductible
- The impact on earnings is positive because money can often be borrowed at a low interest rate and invested at a higher interest rate
Disadvantages of Bonds
- Risk of Bankruptcy because debt and interest are legal obligations that must be paid back as scheduled
- Single large payment is required at maturity date
- Negative impact on cash flow could exist
Types of Long-Term Debt
- Bank Loans
- Notes
- Mortgages
- Bonds and Debentures
Bonds can be traded on…
Established exchanges that provide liquidity to bondholders
As liquidity increases, cost of borrowing decreases
Characteristics of Bonds Payable
- Face Value
- Maturity Data
- Stated Interest Rate
- Interest Payment Date
- Bond Date
- Market Interest Rate
- Issue Date
Types of Bonds Payable
- Debenture bonds (unsecured bond)
No assets are pledged as guarantee of repayment at maturity. - Secured bonds
Specific assets are pledged as guarantee of repayment at maturity. - Callable bonds
Bond may be called for early retirement by the issuer. - Convertible bonds
Bond may be converted to other securities (usually common shares). - Retractable bonds
Bond may be turned in for early retirement at the option of the bondholder.
Senior Debt vs Subordinated Debt
Senior Debt receives preference over other creditors in the event of bankruptcy or default.
Subordinated DebtSubordinated Debt is riskier than senior debt.
Bond Indenture and Covenants
legal document detailing the terms and conditions between the bond issuer and the bondholders. It includes covenants, which are agreements designed to protect creditors by ensuring the issuer maintains certain financial ratios or follows specific guidelines.
Prospectus
The bond issuer prepares a prospectus, which is a formal document that offers details about the bond issue. It describes the issuing company, the details of the bond itself, and how the raised funds will be used. This document is essential for investors to make informed decisions.
Trustee
A trustee is appointed to act on behalf of bondholders to ensure that the bond issuer fulfills all of the provisions set out in the bond indenture. The trustee has a fiduciary responsibility to protect the interests of the bondholders.
Bonds payable
long-term debt for the issuing
company.
The interest rate used to compute the present value is…..
The market interest rate
The stated (coupon) rate (coupon) rate is only used to……
compute the periodic interest
payments.
Stated Interest > Market Interest
Bond’s issued at a premium
Stated Interest < Market Interest
Bond’s issued at a discount
Stated Interest == Market Interest
There is no difference
Reporting Interest Expense: Effective Interest
- The effective interest method is the theoretically preferred method.
- Compute interest expense by multiplying the current unpaid
balance times the market rate of interest. - The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest.
Reporting Interest Expense: Straight-Line
- The effective-interest method of amortization is preferred by IFRS.
- The straight-line amortization may be used by Canadian private enterprises (ASPE) if it is not materially different from the effective interest amortization.
Steps:
- Identify the amount of the bond discount.
- Divide the bond discount by the number of interest periods.
- Include the discount amortization amount as part of the periodic interest expense entry.
- The discount will be reduced to zero by the maturity date.
Early Retirement of Debt: Carrying Amount > Retirement Price = …
Gain
Early Retirement of Debt: Carrying Amount < Retirement Price = …
Loss
Cash Flows
- Issue of bonds (cash inflow)
- Retire debt (cash outflow)
- Repay bond principal at maturity (cash outflow)
- Remember that payment of interest under IFRS is generally an operating activity.
Debt-to-Equity Ratio
This ratio shows the relationship between the amount of capital provided by owners the amount provided by capital provided by owners and the amount provided by creditors. In general, a high ratio suggests that creditors. In general, a high ratio suggests that a
company relies heavily on funds provided by creditors. the company relies heavily on funds provided by creditors.
Total Liabilities / Shareholders Equity
Time Interest Earned Ratio
Net Earnings + Interest
expense + Income tax expense / Interest expense
The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed as more favorable than a low ratio.
