Chapter 9 Part 2

Question 1

Bonds

Answer 1

Long term debt sold to creditors
Bonds make 2 promises
1. repayment of bond principle at maturity (face value of the bond)
2. period interest payments; based on the bond principal/ face value/ par value

Question 2

Face value

Answer 2

(par value) the denomination of the bond, bonds are usually sold in $1000 denominations, and its the amount due at maturity

Question 3

Coupon

Answer 3

(stated, face) interest rate- fixed rate of interest that will be paid each interest payment, set by issuing company

Question 4

Market

Answer 4

(effective, yield) Interest rate- rate of interest that bondholders
(investors) could obtain by investing in other bonds that are similar to the issuing firms bonds, set by bond market

Question 5

term bond

Answer 5

all bonds mature on the same date

Question 6

serial bond

Answer 6

bonds retire in installments

Question 7

debenture bonds

Answer 7

unsecured, not backed by collateral, look at general credit worthiness of company

Question 8

secured bonds

Answer 8

bonds backed by specific collateral

Question 9

callable bonds

Answer 9

corporation reserves right to buy them back early at a stated price (call price or redemption price)

Question 10

convertible bonds

Answer 10

can be exchanged for a stated # shares of common stock

Question 11

Bond indenture

Answer 11

bond contract, specifies all legal provisions of bond (rates, dates, etc.)

Question 12

how bonds are sold

Answer 12

• the selling price of bonds is affected by the difference between coupon rate and market rate

sold 3 ways:
1. @ face (par) value, coupon= market

2. @ a discount, coupon< market
3. @ a premium, coupon> market

Question 13

selling price of bonds

Answer 13

• dependent on time value of money

selling price= PV of face amount + PV of Cash Interest Payments

Question 14

computing the selling price of bonds

Answer 14

step 1: find cash interest payments: Cash interest payment= FV x Coupon %

Step 2: find PV of face amount:
PV= FV x PV of $1 (%Mkt, n)

Step 3: Find PV of cash interest payments
PV= PMT x PVOA (%Mkt, n)

Step 4: Add PV of Face + PV of PMT’s
Selling price of bond (cash proceeds of the company)

Question 15

Journal entries to record for bonds sold at face value

Answer 15

Date of issuance:
Cash xx
Bond payable xx

Date of each cash interest payment:
Interest expense xx
Cash xx

Question 16

journal entries to record for bond sold at a discount

Answer 16

Date of issuance
Cash xx
discount xx
Bond Payable xx (@ FV)

Balance sheet:
Bond payable- discount= carrying value

Question 17

Bonds sold at a discount

Answer 17

to find PV of Face amount:
FV x PV of $1 = PV

PV of cash interest payments:
PMT x PvoA= PV

to find cash interest payments:
cash int. pmts= Face value x Coup%

Question 18

to determine interest expense using effective interest method

Answer 18

rules:
1. use Market rate % o find int. expense- the true cost of borrowing is the market rate

2. use coupon or stated rate % to find cash interest payment only

Question 19

effects of a discount

Answer 19

1. increases the cost of borrowing (received less today, but must pay back face value at maturity
2. amortization of discount increases interest expense because int. expense is calculated based on carrying value & true cost of borrowing
3. carrying value increase over life of bond until it reaches its face value at maturity

Question 20

how to find total cost to borrow with discounts

Answer 20

1. cash outflow vs. cash inflow
2. add discount to cash interest payments

Question 21

Bonds sold at a premium

Answer 21

coupon rate> market rate

to find PV or Face amount
FV x PV of 1= PV

to find PV of cash interest payments
first find cash int payments= FV x Coupon %
then that number x PVoA= PV

Question 22

Journal entry for bond sold at a premium

Answer 22

date of issuance:
Cash xx
Bond payable xx
Premium xx

Question 23

Interest expense

Answer 23

CV (carrying value) x mkt %

Question 24

Interest payment

Answer 24

FV x Coup %

Question 25

effects of a premium

Answer 25

1. premium reduces the cost of borrowing (received more up front and must pay back only face value at maturity)
2. amortization of premium reduces interest expense ( market rate- the actual cost of borrowing is less than the coupon rate)
3. carrying value of bond is reduces over its life until it reaches face value at maturity

Question 26

how to find total cost to borrow with premium

Answer 26

1. cash outflow vs. cash inflow
2. subtract premium from cash interest payments

Question 27

bond prices and market interest rates

Answer 27

there is an inverse relationship between them

if market interest rates increase, bond prices decrease

if market interest rates decrease, bond prices increase

Question 28

retirement of bonds

Answer 28

1. if you retire at maturity (when face value = carrying value) then theres no gain or loss
2. if you retire early
   a. callable bonds- corporation buys bonds back at call price
   b. repurchase through market- pay prevailing market rate
3. Gain/ Loss on retirement
   a. repurchase price< carrying value = gain (credit)
   b. repurchase price> carrying value= loss (debit)