Chapter 10: Bonds

Question 1

Advantages of Bonds

Answer 1

• 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

Question 2

Disadvantages of Bonds

Answer 2

• 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

Question 3

Types of Long-Term Debt

Answer 3

1. Bank Loans
2. Notes
3. Mortgages
4. Bonds and Debentures

Question 4

Bonds can be traded on…

Answer 4

Established exchanges that provide liquidity to bondholders

As liquidity increases, cost of borrowing decreases

Question 5

Characteristics of Bonds Payable

Answer 5

1. Face Value
2. Maturity Data
3. Stated Interest Rate
4. Interest Payment Date
5. Bond Date
6. Market Interest Rate
7. Issue Date

Question 6

Types of Bonds Payable

Answer 6

1. Debenture bonds (unsecured bond)
   No assets are pledged as guarantee of repayment at maturity.
2. Secured bonds
   Specific assets are pledged as guarantee of repayment at maturity.
3. Callable bonds
   Bond may be called for early retirement by the issuer.
4. Convertible bonds
   Bond may be converted to other securities (usually common shares).
5. Retractable bonds
   Bond may be turned in for early retirement at the option of the bondholder.

Question 7

Senior Debt vs Subordinated Debt

Answer 7

Senior Debt receives preference over other creditors in the event of bankruptcy or default.

Subordinated DebtSubordinated Debt is riskier than senior debt.

Question 8

Bond Indenture and Covenants

Answer 8

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.

Question 9

Prospectus

Answer 9

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.

Question 10

Trustee

Answer 10

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.

Question 11

Bonds payable

Answer 11

long-term debt for the issuing
company.

Question 12

The interest rate used to compute the present value is…..

Answer 12

The market interest rate

Question 13

The stated (coupon) rate (coupon) rate is only used to……

Answer 13

compute the periodic interest
payments.

Question 14

Stated Interest > Market Interest

Answer 14

Bond’s issued at a premium

Question 15

Stated Interest < Market Interest

Answer 15

Bond’s issued at a discount

Question 16

Stated Interest == Market Interest

Answer 16

There is no difference

Question 17

Reporting Interest Expense: Effective Interest

Answer 17

• 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.

Question 18

Reporting Interest Expense: Straight-Line

Answer 18

• 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.

Question 19

Early Retirement of Debt: Carrying Amount > Retirement Price = …

Answer 19

Gain

Question 20

Early Retirement of Debt: Carrying Amount < Retirement Price = …

Answer 20

Loss

Question 21

Cash Flows

Answer 21

• 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.

Question 22

Debt-to-Equity Ratio

Answer 22

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

Question 23

Time Interest Earned Ratio

Answer 23

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.