Chapter 9 Part 2 Flashcards
Bonds
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
Face value
(par value) the denomination of the bond, bonds are usually sold in $1000 denominations, and its the amount due at maturity
Coupon
(stated, face) interest rate- fixed rate of interest that will be paid each interest payment, set by issuing company
Market
(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
term bond
all bonds mature on the same date
serial bond
bonds retire in installments
debenture bonds
unsecured, not backed by collateral, look at general credit worthiness of company
secured bonds
bonds backed by specific collateral
callable bonds
corporation reserves right to buy them back early at a stated price (call price or redemption price)
convertible bonds
can be exchanged for a stated # shares of common stock
Bond indenture
bond contract, specifies all legal provisions of bond (rates, dates, etc.)
how bonds are sold
- 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
- @ a discount, coupon< market
- @ a premium, coupon> market
selling price of bonds
- dependent on time value of money
selling price= PV of face amount + PV of Cash Interest Payments
computing the selling price of bonds
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)
Journal entries to record for bonds sold at face value
Date of issuance:
Cash xx
Bond payable xx
Date of each cash interest payment:
Interest expense xx
Cash xx
journal entries to record for bond sold at a discount
Date of issuance
Cash xx
discount xx
Bond Payable xx (@ FV)
Balance sheet:
Bond payable- discount= carrying value
Bonds sold at a discount
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%
to determine interest expense using effective interest method
rules:
1. use Market rate % o find int. expense- the true cost of borrowing is the market rate
- use coupon or stated rate % to find cash interest payment only
effects of a discount
- increases the cost of borrowing (received less today, but must pay back face value at maturity
- amortization of discount increases interest expense because int. expense is calculated based on carrying value & true cost of borrowing
- carrying value increase over life of bond until it reaches its face value at maturity
how to find total cost to borrow with discounts
- cash outflow vs. cash inflow
- add discount to cash interest payments
Bonds sold at a premium
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
Journal entry for bond sold at a premium
date of issuance:
Cash xx
Bond payable xx
Premium xx
Interest expense
CV (carrying value) x mkt %
Interest payment
FV x Coup %
effects of a premium
- premium reduces the cost of borrowing (received more up front and must pay back only face value at maturity)
- amortization of premium reduces interest expense ( market rate- the actual cost of borrowing is less than the coupon rate)
- carrying value of bond is reduces over its life until it reaches face value at maturity
how to find total cost to borrow with premium
- cash outflow vs. cash inflow
- subtract premium from cash interest payments
bond prices and market interest rates
there is an inverse relationship between them
if market interest rates increase, bond prices decrease
if market interest rates decrease, bond prices increase
retirement of bonds
- if you retire at maturity (when face value = carrying value) then theres no gain or loss
- if you retire early
a. callable bonds- corporation buys bonds back at call price
b. repurchase through market- pay prevailing market rate - Gain/ Loss on retirement
a. repurchase price< carrying value = gain (credit)
b. repurchase price> carrying value= loss (debit)
