chapter 8 - liabilities on slide deck

Question 1

what are the risk + interest factors that yield the following generalizations of the present value of a single payment

Answer 1

1. the right to receive an amount now (present value) is worth more than teh right to receive the same amount later (future value)
2. the longer we must wait to receive an amount the less attractive it is
3. the greater the interest rate the greater the amount we will receive in the future
4. the more risk associated with a cash flow, the higher the interest rate

Question 2

how to use a present value table

Answer 2

determine the number of interest compounding periods (years may not = compounding periods)

determine the interest rate per compounding period - often the interest rates are quoted on an annual basis; the rate per compounding period is the annual rate divided by the number of compounding periods per year - if the interest rate is 10% per year, then the compounded interest rate is 5% per period if compounded semiannually

locate the present value factor and multiple this factor by the dollars that will be paid in the future

Question 3

how do we know if we have an annuity

Answer 3

if the payment or receipt (cash flow) is equally spaced over time and each cashflow is the same dollar amount

Question 4

what does a bond agreement specify in terms of future cash flows

Answer 4

a series of interest payment
a single payment of the face amount at maturity

Question 5

define market rate on the date of the sale of a bond

Answer 5

the rate we use to determine the bond’s market value (its price)

Question 6

how to determine the selling price of a bond

Answer 6

1. compute the present value of the future principal payment at the prevailing market rate (using table of present of single future payment)
2. compute the present value of the future series of interest payments (the annuity) at the prevailing market rate (using table for present value of an annuity)
3. add the present values from steps 1 + 2

Question 7

what are the 2 interest rates that set the bond price - why do these 2 interest rates differ

Answer 7

1. stated interest rate (coupon rate)
   - printed on bond certificate
   - determines interest payment amount to shareholders
2. market interest rate (effective interest rate)
   - demanded by investors for loaning money
   - varies minute to minute

these two interest rates often differ bc of the time that passes between when a bond issue is established and when it’s actually sold

Question 8

when do bonds sell at a discount or at a premium?

Answer 8

bonds sell at discount when the coupon rate is less than market rate

bonds sell at premium when the coupon rate is greater than market rate

Question 9

what’s the effective rate of a bond

Answer 9

bonds are priced to yield the return (market rate) demanded by investors

thus the effective rate of a bond always equals the yield demanded by investors, regardless of the bond’s coupon rate

means that the companies cannot influence the effective cost of debt by raising or lowering the coupon rate –> doing this only results in a bond premium or discount

Question 10

what’s the importance of the effective cost of debt

Answer 10

effective cost of debt is used to determine interest expense reported in the issuer’s income statement

interest expenses = usually different from the cash interest paid bc of bond discounts and premiums

Question 11

how to read the price quote from the bloomberg screenshot

Question 12

what’s the journal entries for issuing bonds at par, their interest payment, at year-end (of 1 year), at maturity

Answer 12

issuing bond: Dr. Cash
Cr. Bonds Payable

paying interest:
Dr. interest expense
Cr. cash

at year end:
Dr. interest expense
Cr. interest payable - (payable next day, it’s an accrued liability)

at maturity
Dr. bond payable
Cr. cash

Question 13

what’s the J/E for issuing a bond at discount

Answer 13

Dr. cash (96)
Dr. discount on bonds payable (4)
CR. bonds payable (100)

difference between the face value and the issue price = discount on bonds payable

Question 14

what’s the J/E for issuing bonds payable at a premium

Answer 14

DR. Cash (104)
CR. bonds payable (100)
CR. premium on bonds payable (4)

where the premium on bonds payable is the difference between the face value and the issue price

Question 15

what happens to the balance of the discount account and premium account over the life of the bond issue

Answer 15

they’re amortized

for discounts: discount is allocated to interest expense through amortization each period over the term of the bond –> the discount on the bonds increases the bonds’ interest expense each period over the term of the bonds (bond price increases each period until it reaches face value, interest payment remains constant but the interest expense increases - this increase is capture in the price of the bond?)

for premiums: the premium is allocated to the interest expense through amortization each period over the term of the bond –> the premium on the bonds decreases the bonds’ interest expense each period over the term of the bonds. (bond price decrease each period until it reaches face value, interest payment remains constant but the interest expense decrease over the bond terms - as you’re paying the premium part with it?)

Question 16

do fluctuations in market rate of bond affect company?

Answer 16

no after issuance date of the bond, fluctuations in market rate don’t affect company unless they buy back bonds

Question 17

calculate the gains and losses on bond retirements

Answer 17

gain or loss on bond repurchase = net bonds payable - repurchase payment

net bonds payable (book value/carrying value) = net amount reported on balance sheet

if issuer pays more to retire the bonds than the amount carried on its balance sheet, reports a loss on I/S

if issuer reports a gain on bond retirement if the repurchase price is less than the net bonds payable