Long-term

Liabilities

© Copyrright Doug Hillman 2000

 Bonds
 Written promise to pay a specific sum of
money on a speciific future date
 Purchaser is bondholder
 Receives Bond certificate

© Copyrright Doug Hillman 2000

 Classification of Bonds
 Registered - issued in name of holder
 Secured - assets pledged as security
 Debenture (unsecured) - based on
general credit
 Serial - mature in installments
 Callable - corporation has option of
retiring

© Copyrright Doug Hillman 2000

 Bonds Compared to Stock
 Bondholders are
creditors
 Bonds a liability
 Interest is fixed charge
 Interest is expense
 Interest tax deductible
 No voting
© Copyrright Doug Hillman 2000
 Stockholders are
owners
 Stock is equity
 Dividends not fixed
charges
 Dividends not expense
 Dividends not tax
deductible
 Voting
 Financial Leverage
 Borrowed money invested within business
to earn a higher rate than borrowing cost
 When positive financial leverage occurs,
use of bonds will produce higher EPS than
financing same investment with stock
 Use of bonds will also produce higher
amount available for reinvestment

© Copyrright Doug Hillman 2000

 Bond Terms
 Face value
› The principal of the bond payable at
maturity
 Stated interest rate

› The rate multiplied by face value to get

periodic cash interest payment
 Term

› Time to maturity

© Copyrright Doug Hillman 2000

 Why Bonds Sell at
Discount or Premium
 When market interest rate on
comparable grade bonds is higher or
lower than the stated rate,

© Copyrright Doug Hillman 2000

 Why Bonds Sell at
Discount or Premium
 When market interest rate on
comparable grade bonds is higher or
lower than the stated rate, investors will
adjust the purchase price of the bond so
that they earn the desired market
interest rate

© Copyrright Doug Hillman 2000

 Why Bonds Sell at
Discount or Premium
 Why Bonds Sell at Discount or
PremiumWhen market interest rate on
comparable grade bonds is higher or lower
than the stated rate, investors will adjust
the purchase price of the bond so that they
earn the desired market interest rate
 Issuing price determines effective or yield
rate

© Copyrright Doug Hillman 2000

 Why Bonds Sell at
Discount or Premium
 If the market rate is higher than stated
rate, investors will offer less than face
value
 Difference between price paid and face
value is discount
 Effective interest rate is higher than
stated interest rate

© Copyrright Doug Hillman 2000 1

 Why Bonds Sell at
Discount or Premium
 If market rate is lower than stated rate,
investors will offer more than face value
 Difference between price paid and face
value is premium
 Effective interest rate is lower than
stated interest rate

© Copyrright Doug Hillman 2000 1

 Sales Price of Bond
 Bond promises two future cash flows
› Periodic interest payments
› Principal at maturity
 Price of bond today is the sum of the
present value of these two future cash
flows discounted at the interest rate the
investor desires to earn (market rate)

© Copyrright Doug Hillman 2000 1

 Calculation of Bond Price
 Assume $100,000, 10%, 10 year bond,
interest payable semiannually on 6/30
and 12/31, market interest rate 12%
 Since the market interest rate (12%) is
higher than the stated interest rate
(10%), the bond should sell at a
discount

© Copyrright Doug Hillman 2000 1

 Calculation of Bond Price
 PV of face amount (i=6%,n=20)
› $100,000 x 0.312 = $31,200
 PV of interest payments

› $5,000 x 11.470 = $57,350

 Price of bond = $88,550

© Copyrright Doug Hillman 2000 1

 Issuance of Bonds
 Increase Cash for the proceeds of
issuance
 Increase Bonds Payable for face value
 Increase Premium or Discount for the
difference

© Copyrright Doug Hillman 2000 1

 Amortization of
Premium or Discount
 The premium or discount is an adjustment
to the interest
 To record the proper interest expense, we
must amortize the premium or discount
 Two methods

› Straight-line - constant amortization

› Effective interest - constant effective rate

© Copyrright Doug Hillman 2000 1

 Recording Interest
Straight-Line
 Decrease Cash for
› Face amount x Stated rate X Time
 Decrease Premium or Discount for

› Premium or Discount / Time to

maturity
 Increase Interest Expense for

› Sum of cash and amortization

© Copyrright Doug Hillman 2000 1

 Recording Interest
Effective Interest Method
 Decrease Cash for
› Face amount x Stated Rate x Time
 Increase Interest Expense for

› Carrying value x Effective Interest Rate x

Time
 Decrease Premium or Discount for

› The difference between cash and interest

expense

© Copyrright Doug Hillman 2000 1

 Discount Amortization
Example
 $10,000, 10%, 2 year bond
 Interest payable semiannually
 Market interest rate 11%
 Issue price $9,822.50

© Copyrright Doug Hillman 2000 1

 Discount Amortization
Straight-Line
Pd Cash Exp Amort CV
0 9,822.50
1 500.00 544.38 44.38 9,866.88
2 500.00 544.38 44.38 9,911.26
3 500.00 544.38 44.38 9,955.64
4 500.00 544.38 44.36 10,000.00

© Copyrright Doug Hillman 2000 2

 Proof of Interest
Future cash payments
Face $10,000.00
Interest 2,000.00
Total $12,000.00
Cash received 9,822.50
Total interest $2,177.50
Semiannual interest
$2,177.50 / 4 = $544.38

© Copyrright Doug Hillman 2000 2

 Discount Amortization
Effective Interest
Pd Cash Exp Amort CV
0 9,822.50
1 500.00 540.24 40.24 9,862.74
2 500.00 542.45 42.45 9,905.19
3 500.00 544.79 44.79 9,949.98
4 500.00 547.25 47.25 *9,997.23
*rounding error

© Copyrright Doug Hillman 2000 2

 Premium Amortization
Example
 $10,000, 10%, 2 year bond
 Interest payable semiannually
 Market interest rate 9%
 Issue price $10,184.00

© Copyrright Doug Hillman 2000 2

 Premium Amortization
Straight-Line
Pd Cash Exp Amort CV
0 10,184.00
1 500.00 454.00 46.00 10,138.00
2 500.00 454.00 46.00 10,092.00
3 500.00 454.00 46.00 10,046.00
4 500.00 454.00 46.00 10,000.00

© Copyrright Doug Hillman 2000 2

 Proof of Interest
Future cash payments
Face $10,000.00
Interest 2,000.00
Total $12,000.00
Cash received 10,184.00
Total interest $1,816.00
Semiannual interest
$1,816.00 / 4 = $454.00

© Copyrright Doug Hillman 2000 2

 Premium Amortization
Effective Interest
Pd Cash Exp Amort CV
0 10,184.00
1 500.00 458.28 41.72 10,142.28
2 500.00 456.40 43.60 10,098.68
3 500.00 454.44 45.56 10,053.12
4 500.00 452.39 47.61 *10,005.51
*rounding error

© Copyrright Doug Hillman 2000 2

 Issuance Between
Interest Dates
 Interest since last interest payment date
accrues to date of issuance at the stated
rate
 Proceeds of issuance include

› Market price of bond

› Accrued interest
–Accrued interest increases Interest
Payable

© Copyrright Doug Hillman 2000 2

 Issuance Between
Interest Dates
 Next interest payment is for full 6
months and pays off Interest Payabe
 Resulting interest expense is only for
period since issuance

© Copyrright Doug Hillman 2000 2

 Mortgage Notes Payable
 Long-term note with assignment of an
interest in property
 Mortgage paid in equal periodic installments
 Each payment includes

› Interest at specified rate on unpaid

principal
› Reduction of principal for difference
between payment and interest

© Copyrright Doug Hillman 2000 2

 Analyzing Information
 Is the level of total debt manageable?
 Does it seem likely interest and principal
payments can be met?
› Times Interest Earned ratio
› Debit ratio
 If firm needs additional financing, would
you recommend lending or investing in it?

© Copyrright Doug Hillman 2000 3