Chapter 10

Bonds
Preview
• Characteristics of Bonds
• Report bonds payable and interest expense
• For bonds sold at par, discount, or premium
• Key ratios:
• Times interest earned
• Debt-to-equity ratio and financial leverage

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Characteristics of Bonds

• Bonds are Long-Term Debts

• Classify Bonds
• Characteristics of Bonds
• Timeline of Bonds 3
What is Bond?

4
Bonds: Long-Term Debts
• Bonds are notes and debentures issued to investors of bonds
(those who want to invest in corporate bonds). They are
issued for long-term purposes.
• Example: see the handouts

5
Bonds: Long-Term Debts
Advantages Disadvantages
• Stockholders maintain • Risk of bankruptcy
control (liquidity risk)
• Interest expense is tax • Negative impact on cash
deductible flows in the future—
• Impact on earnings is when interests and
positive—if the firm is principal are paid
making more money
than interests

6
Classification of Bonds
• Classify by whether or not the bond is secured
• Secured bond
• The issuer (i.e., the company who issued the bond) specifies which
assets are pledged as a guarantee of repayment at maturity.
• Unsecured bond (a/k/a debenture)
• No assets are pledged as a guarantee of repayment at maturity.
• Classify by special feature
• Callable bond
• The issuer has the right to repay the bond before it is due, i.e., call
the bond for early retirement.
• Convertible bond
• The bond may be converted to common stock of the issuer
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Characteristics of Bonds
• Information on the bond contract:
• Face value (par value, principal, maturity value)
• Bond date (date of borrowing)
• Maturity date (date when the bond is due)
• Stated interest rate: the % on the bond contract
• Interest payment dates (when the interests are paid)
• Special features, if there is any
• Information not on the bond document:
• Market interest rate: the % that the market uses

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Life of Bonds
• When issue: a company issues bonds and receives cash from
investors of bonds
• After issuance and before repayment of bond: (periodic
interest payments to bond-holders)
• On the retirement or maturity of bond: the company repays
principal and interests that have not been paid to bond-
holders

9
Example of GE
• Find the following information of the bonds GE issued in 2014:
• Face value
• Bond date
• Maturity date
• Stated interest rate
• Interest payment dates
• Bond issue price

10
Reporting of Bonds

• Reporting the Issuance: Issue Price

• Reporting the Issuance: When Market Rates <> Stated Interest
• Reporting the Issuance: Discount and Premium
• Reporting Bond Liabilities on Financial Statements
• Reporting Interest Expense: Amortization of Discount and Premium 11
• Reporting the Retirement
Calculating the Value of Bonds
• Bond value is the sum of the following:
(A) A single payment at maturity (the amount is face value)
(B) An annuity (periodic interest payments before maturity)
• Example 1:
• Face value: $1,000
• Coupon rate (i.e., the stated interest rate): 6%
• Market rate when the bond was issued: 6%
• Issue date: December 31, 2010. Maturity date: December 31, 2013.
• Coupon (i.e., interest) payment frequency: annual
• Value of the bond when issued?
(1) PV of $1,000 at the interest rate of 6% and number of periods = 3.
PV = $840
(2) PV of an annuity with equal payments of $1000*6% = $60 at the
interest rate of 6% and number of periods = 3.
PV = $160
• Total PV = $1,000. When market rate = coupon rate, PV = face value. 12
Calculating the Value of Bonds
• Bond value is the sum of the following:
(A) A single payment at maturity (the amount is face value)
(B) An annuity (periodic interest payments before maturity)
• Example 2:
• Face value: $1,000
• Coupon rate (i.e., the stated interest rate): 6%
• Market rate when the bond was issued: 12%
• Issue date: December 31, 2010. Maturity date: December 31, 2013.
• Coupon (i.e., interest) payment frequency: annual
• Value of the bond when issued?
(1) PV of $1,000 at the interest rate of 12% and number of periods = 3
PV = $712
(2) PV of an annuity with equal payments of $1000*6% = $60 at the
interest rate of 12% and number of periods = 3
PV = $144
• Total PV = $856. When market rate ≠ coupon rate, PV ≠ face value. 13
Calculating the Value of Bonds
• Did you notice?
• We use the market interest rate when the bond was issued as our
discount rate when calculating the PV
• We use the coupon rate only to calculate the periodic coupon
payment
• We calculated the “annual” periodic coupon payment because
the coupon is paid once a year
• What if the coupon is paid semi-annually (twice a year)?
• PV of the face value $1,000 does not change
• PV of the annuity changes as follows: equal payments of $1000*6%/2 =
$30 at the interest rate of 12%/2=6% and number of periods = 3*2 = 6
• What if the coupon is paid quarterly?

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Value of Bonds: Market vs. Stated Rate
• The coupon rate • The market rate
determines the determines the
amount of periodic issuing price.
payments. • This is what investors
• This is what issuer will of bonds want for the
pay every period. interests
• The PV we calculated

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Value of Bonds: Market vs. Stated Rate
• When coupon rate = market rate
• Periodic payments = what investors want for interests.
• So, PV (issue price) = face value. Bond is issued at par.
• When coupon rate < market rate
• Periodic payments < what investors want for interests.
• So, PV (issue price) < face value. Bond is issued at a discount.
• When coupon rate > market rate
• Periodic payments > what investors want for interests.
• PV (issue price) > face value. Bond is issued at a premium.

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Reporting Bond Issuance
• Face value is used to record bonds payable
• If the face value is $1,000, we record
Cr. Bonds Payable $1,000
• Issue price is used to record cash receipt
• If the issue price is $1,000 (or $900, or $1,100), we record
Dr. Cash $1,000 (or $900, or $1,100)
• The difference between face value and the issue price:
• If the issue price = face value, bond is issued at par
Dr. Cash $1,000
Cr. Bonds Payable $1,000
• If the issue price < face value, bond is issued at a discount
Dr. Cash $900
Dr. Discount on Bonds Payable $100
Cr. Bonds Payable $1,000
• If the issue price > face value, bond is issued at a premium
Dr. Cash $1,100
Cr. Bonds Payable $1,000 17
Cr. Premium on Bonds Payable $100
Book Value of Debt
• The reported value of long-term debt for a bond
= bonds payable
+ premium on bonds payable (if issued at a premium)
– discount on bonds payable (if issued at a discount)
• The reported value should become the same as bonds payable
when the bond is due
• In other words, we need to reduce the premium (or discount)
over the life of the bond so that the reported value would get
close to the bonds payable amount.
• This is called “amortization” of premium (or discount)

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Amortization of Discount/Premium
• Concept:
• A bond is issued at a discount:
• Over the life of bond: coupon payments + discounts = interests
• Each period: Coupon payment + amortization of discount = interest
expense
• A bond is issued at a premium
• Over the life of bond: coupon payments > interests
• Each period: coupon payments – amortization of premium = interest
expense
• Method:
• Straight-Line: Amount of amortization per period
= total discount (or premium) / total number of payment periods
• And then coupon payments ± amortization = interest expense
• Effective-Interest: Amount of interest expense per period
= Beginning reported value of bond × market rate at issuance 19
• And then interest expense ± coupon payments = amount of amortization
Reporting Interest Expense
• Coupon payment is used to record cash outflow
• If the coupon payment is $100, then record
Cr. Cash $100
• Depending on whether the coupon is issued at par, at discount, or at
premium, we have different interest expenses:
• Issued at par: the coupon payment is also used to record interest expense
Dr. Interest expense $100
Cr. Cash $100
• Issued at a discount: the interest expense = coupon payment + amortization
of discount (suppose it is $X)
Dr. Interest Expense $100+X
Cr. Cash $100
Cr. Discount on Bonds Payable $X
• Issued at a premium: the interest expense = coupon payment – amortization
of premium (suppose it is $Y)
Dr. Interest Expense $100 – Y
Dr. Premium on Bonds Payable $Y 20
Cr. Cash $100
E10-7
• Information about the bonds:
• Principal: $700,000
• Stated interest rate: 8% (annual rate, use this for annual payments)
• Issue date: January 1, 2014
• Maturity date: mature in 10 years  December 31, 2023
• Interest payment frequency: once per year (on each December 31)
• Market interest rate when issued: 9% (annual rate, use this for PV
calculation)
• Issue price: PV of $700,000 (N=10, r=9%) + PV of annual payments
$700,000*8% = $56,000 (N=10, r=9%) = $655,071
• Issue price $655,071 < Principal $700,000  Issue at a discount
• Amortization per year: ($700,000 – $655,071) / 10 = $4,493
• Interest expense per year: cash payment per year $56,000 +
amortization of discount per year $4,493 = $60,493 21
E10-14
• Information about the bonds:
• Principal: $1,400,000
• Stated interest rate: 8% (annual rate, use this for annual payments)
• Issue date: January 1, 2014
• Maturity date: mature in 4 years  December 31, 2017
• Interest payment frequency: twice per year (on each June 30 and
December 31)
• Market interest rate when issued: 6% (annual rate, use this for PV
calculation)
• Issue price: PV of $1,400,000 (N=4*2, r=6%/2) + PV of annual
payments $1,400,000*8%/2 = $56,000 (N=4*2, r=6%/2) =
$1,498,263
• Issue price $1,498,263 > Principal $1,400,000  Issue at a premium
• Amortization per half year: ($1,498,263 – $1,400,000) / (4*2) =
$12,283
• Interest expense per half year: cash payment per half year $56,000 – 22
amortization of premium per half year $12,283 = $43,717
Zero-Coupon Bonds
• Zero-coupon: coupon rate = 0%  no periodic payments
• Everything else the same
• So Issue price = PV of principal + PV of annuity
• Issue price is very small compared to bonds with positive coupons
• Always issued at a discount, and the discount is deep
 Also called a deep discount bond

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Early Retirement of Debt
• Retire means: the issuer repays the bonds (the principal + any
accrued interests of the bonds)
• After retirement, the bonds stop exist.
• Early retirement means: the issuer repays the bonds before maturity
date
• A company may “call” bonds for early retirement. Call features
usually come with a cost (i.e., a loss) to the issuer.
• A company may repurchase bonds on the market for early
retirement. Depending on the market rate at the time of repurchase,
there may be a gain or a loss.
• Ex. If a company issued $1 million of bonds at par with a call option,
which costs 2% of par, then when the company call the bonds, it
would record:
Bonds payable $1,000,000
Loss on bond call $20,000 24
Cash $1,020,000
Important Ratios

• Times Interest Earned

• Capital Structure and Debt-to-Equity Ratio
• Financial Leverage
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• How Financial Leverage Works
Times Interest Earned
• This is a ratio:
𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 + 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
+𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
• The numerator is essentially: earnings before interest and income
tax
• This ratio shows: how many times of money can be earned
given the interest expense (over the same period)
• Times interest earned = 1  earnings are just enough to cover
the interest expense
• Times interest earned = 2  earnings are twice as much as the
interest expense
• So a higher ratio is better 26
Capital Structure and Debt-to-
Equity Ratio
• Capital Structure: the source of funds for a company’s
operations
• Debt: the source of funds is creditors
• Equity: the source of funds is owners (= stockholders)
• Debt-to-equity ratio: Total liabilities/total stockholders’ equity
• Shows the capital structure (and financial leverage) of a company
• If ratio is very high  too much funds from creditors, so very high
risk of bankruptcy
• Similar to the following ratios:
debt-to-asset, asset-to-debt, equity-to-debt, equity-to-asset,
asset-to-equity

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Financial Leverage
• Technique to multiply gains and losses
• If a company needs $200 and it can generate either $20 gains or
$20 losses, then…
• If stockholders contribute $200, they would get either 10% gain
or 10% loss
• $20/$200 = 10%; -$20/$200 = -10%
• If stockholders contribute $100 and the company borrows
another $100 at an interest rate of 5%, then stockholders would
get either 15% gain or 25% loss
• ($20 – $5)/$100 = 15%; (-$20 – $5)/$100 = -25%
• So borrowing amplifies the gains and losses for stockholders

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Financial Leverage and Return
on Equity
• Financial leverage amplifies gains and losses for owners
 Financial leverage and gains/losses have a special relation
Total liabilities > 0  Financial Leverage > 1
ROE: Return on
So if there is a gain (ROA > 0), ROE is even higher;
Equity
if there is a loss (ROA < 0), ROE is even lower

ROE = ROA × Financial Leverage

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑁𝑁𝑁𝑁 𝑁𝑁𝑁𝑁 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 ×
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆
𝑆𝑆𝑆𝑆 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑁𝑁𝑁𝑁 𝑁𝑁𝑁𝑁𝑁𝑁 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
= × 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 ×
𝑁𝑁𝑁𝑁𝑁𝑁 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Net Profit × Assets × Financial 29
Margin Turnover Leverage
Summary Quiz – True of False?
(A) If the market rate when bonds are issued = the coupon rate, then
the issue price of bonds = the principal of bonds.
(B) The higher the market rate when bonds are issued, the lower the
issue price of bonds.
(C) The higher the market rate when bonds are issued, the higher the
total future interest expense of bonds.
(D) The issue price of bonds = PV of principal + PV of periodic
payments.
(E) The market rate is used to calculate PVs.
(F) The coupon rate is used to calculate the periodic payment
amount.
(G) Financial leverage would multiply the gains and losses for
creditors.
(H) If times interest earned = 5, then earnings before interest and 30
income tax are 5 times as much as the interest expense.