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Bonds

LEVERAGE
Income from Debt > Interest on Debt

Debt Pros:
Fixed Payments to Lenders
If Rising Inflation: $ Today < $ Tomorrow
Debt Cons:
Inflexible Payment Schedules Bankruptcy

Bond Terms
What are Bonds?
Large Debt in Small Chunks ($1K)
Too Large for Single Lender
Face Value = Par Value = Principal
Paid at Maturity (Typical)
Monthly (Sometimes)

Interest = Stated =Nominal = Coupon=Contract


(RATE)
Rate on the Bond
Paid Periodically at the RATE

Other Debt Terms

Maturity Date = Final Due Date (Principal)


Market =Effective =Yield (Rate)
Secured = Tied to Asset
Unsecured = Debenture = No Asset
Junk = Unsecured, Risky, High Rate
Callable = Borrower Early Payoff (Mkt Rate
)
Convertible = Lender becomes Stockholder
Indenture = Bond Document

Notes vs. Bonds


Note

Lender
s
Value
Terms
Traded
Regula
r
Payme
nts
Secure
d

One
Vary
Vary
No
Principal
and
Interest
Yes

Bond
Many
$1,000/each
5+ Years
Yes
Interest

Yes and No

Selling Bonds
Why?
No Effect on Company
Ownership/Management
No Dilution of Shares
Interest vs. Dividends

Underwriters (Sellers)
Determine Market Rate for Bond
Assume Risk of Bonds from Issuer (Buy)
Resell Bonds (Sell)

Stated vs. Market (Yield)


Interest
PREMIUM:

PAR:

Stated> Market > IP IE

Stated =Market

DISCOUNT: Stated<

=IP IE

Market< IP IE

Accounting for LT Debt


Cash Flows
@Issue
Interest Payments
Maturity (Face Value)
Issue
$100,000
(Cash In)

Interest
Payment
$10,000

Interest
Payment
$10,000

Face Value:
$100,000
Due: 4 Years
Stated Rate: 10%

Interest
Payment
$10,000

Interest
Payment
$10,000
Maturity
$100,000

Bond Issue Pricing


PV of Bond @ Maturity
+ PV of Bond Interest Payments
Bond Issue Price (Cash)
1) Principal Bond Value (PV of $1 @
Market Rate)
2) Interest Payments (PV of Annuity @
Market Rate)

Bonds Issue Pricing


On
On January
January 1,
1, 2014,
2014, AT&T
AT&T issues
issues $100,000
$100,000 in
in
bonds
bonds having
having aa 10%
10% annual
annual stated
stated rate
rate of
of
interest.
interest. The
The bonds
bonds mature
mature in
in 22 years
years (Dec.
(Dec.
31,
31, 2015)
2015) and
and interest
interest is
is paid
paid semiannually.
semiannually.
The
The annual
annual market
market rate
rate of
of interest
interest is
is 12%.
12%.

Bonds Issue Pricing


First,
compute the
present value
of the
principal.

Market
Market rate
rate of
of 12%
12%
22 interest
interest periods
periods per
per year
year
=
= 6%
6%
Bond
Bond term
term of
of 22 years
years
22 periods
periods per
per year
year =
= 44
periods
periods

Bonds Issue Pricing


Now,
compute the
present value
of the
interest.
Market
Market rate
rate of
of 12%
12%
22 interest
interest periods
periods per
per year
year
=
= 6%
6%
Bond
Bond term
term of
of 22 years
years
22 periods
periods per
per year
year =
= 44
periods
periods

Bonds Issued at ?
Finally,
determine
the issue
price of the
bond.

Bond Issue Journal Entry

Bonds Issue Pricing


On
On January
January 1,
1, 2014,
2014, AT&T
AT&T issues
issues $100,000
$100,000 in
in
bonds
bonds having
having aa 10%
10% annual
annual stated
stated rate
rate of
of
interest.
interest. The
The bonds
bonds mature
mature in
in 22 years
years (Dec.
(Dec.
31,
31, 2015)
2015) and
and interest
interest is
is paid
paid semiannually.
semiannually.
The
The annual
annual market
market rate
rate of
of interest
interest is
is 8%.
8%.

Bonds Issue Pricing


First,
compute the
present value
of the
principal.

Market
Market rate
rate of
of 8%
8%
22 interest
interest periods
periods per
per year
year
=
= 4%
4%
Bond
Bond term
term of
of 22 years
years
22 periods
periods per
per year
year =
= 44
periods
periods

Bonds Issue Pricing


Now,
compute the
present value
of the
interest.

Market
Market rate
rate of
of 8%
8%
22 interest
interest periods
periods per
per year
year
=
= 4%
4%
Bond
Bond term
term of
of 22 years
years
22 periods
periods per
per year
year =
= 44
periods
periods

Bonds Issue Pricing


Finally,
determine
the issue
price of the
bond.

Bonds Issued at Premium

The
premium
will be
amortized
over the 2year life of
the bonds.

Journal Entries
At Issue

PAR (Stated = Market)


Dr. Cash
$100K
Cr. Bonds Payable
$100K
Premium (Stated >Market) 103
Dr. Cash $103K
Cr. Bonds Payable
$100K
Cr.
Premium on Bonds Payable
Discount (Stated<Market) 94
Dr. Cash
$94K
Dr. Discount on Bonds Payable $6K
Cr.
Bonds Payable $100K

$3K

Discount/Premium Accounts
PREMIUM ON BONDS PAYABLE
Adjunct-Liability

DISCOUNT ON BONDS PAYABLE


Contra-Liability

Amortization Methods
Amortization = Amount of Interest Payment +Disc
(Prem) Expensed over Time
METHODS
Straight Line
Equal amounts over time
Not GAAP (Except @ PAR)

Effective Interest
Market Rate x BV of Bonds(Beg of Period)
Similar to Compound Interest Calculations
GAAP

Straight-Line Method
AMOUNT OF
PREMIUM or DISCOUNT
=DISCOUNT/PREMIU
# of PERIODS
M AMORTIZED PER
PERIOD(DA/PA)
(FACE VALUE x STATED RATE)
Plus: Discount Amortization Amt.
Less: Premium Amortization Amt.
INTEREST EXPENSE

STRAIGHT-LINE MATRIX

BEG
DATE BV

CONSTANT

AMORTIZA
INTEREST TION AMT
EXPENSE
D(P)
(PREM or
DISC)/
B+D
PERIODS
CONSTANT CONSTANT

INTEREST
PAYMENT
FV x STATED
RATE

END BV
A+B

AT&T
AT&T issued
issued $100K
$100K bonds
bonds on
on Jan.
Jan. 1,
1, 2014.
2014.
The
The bonds
bonds sold
sold for
for $96,536.
$96,536. The
The bonds
bonds
have
have aa 2-year
2-year maturity
maturity and
and $5,000
$5,000
interest
interest is
is paid
paid semiannually.
semiannually.

DATE
1/1/2014
6/30/2014

Compute
Compute the
the periodic
periodic discount
discount
amortization
amortization using
using the
the straight-line
straight-line
method.
A
B method.
C
D

BEG BV

$
96,536

$
12/31/2014 97,402
$
6/30/2015
98,268

INTERES
T
AMORTIZAT
PAYMEN INTEREST ION AMT
T
EXPENSE
(D/P)
END BV
$

96,536
$
$
$
$
5,000
5,866
866
97,402
$
$
$
$
5,000
5,866
866
98,268
$
$
$
$
5,000
5,866
866
99,134

Journal Entries for


Interest Expenses
PAR (Stated = Market)
Dr. Interest Expense
$100
Cr. Cash
$100
Premium (Stated >Market)
Dr. Interest Expense
$97
Dr. Premium on Bonds Payable
Cr.
Cash
$100
Discount (Stated<Market)
Dr. Interest Expense
$106
Cr. Discount on Bonds Payable
Cr. Cash
$100

$3

$6

Effective Interest Rate


Method
= EIRM
If @PAR then SL
Total Interest Expense =
SL EIRM
BOOK VALUE x MARKET RATE =
INTEREST EXPENSE
FACE VALUE x STATED RATE
= < INTEREST PAID
(CASH)>
AMORTIZATION AMT
(D/P)

A
B
C
D
E
F
DAT BEG
E
BV

MARKET
(YIELD)

INTEREST
EXPENSE

INTEREST
PAYMENT

(A x B)
BV x
MARKET

CONSTANT
FV x STATED
RATE

CONSTANT

AMORTIZATI
ON AMT
END
(PA/DA)
BV
(A+E
(C-D)
)

AT&T
AT&T issued
issued $100K
$100K bonds
bonds on
on Jan.
Jan. 1,
1, 2014.
2014.
The
The bonds
bonds sold
sold for
for $96,536.
$96,536. The
The bonds
bonds
have
have aa 2-year
2-year maturity
maturity and
and $5,000
$5,000
interest
interest is
is paid
paid semiannually.
semiannually. The
The stated
stated
rate
rate on
on the
the bonds
bonds is
is 10%.
10%. The
The market
market
rate
rate at
at the
the time
time the
the bonds
bonds were
were sold
sold was
was
12%
12%

DATE

A
B the periodic
C
D discount
E
F
Compute
Compute
the periodic
discount
AMORTIZA
amortization
using
the
effective
interest
amortization
using
the
effective
Market
INTEREST INTEREST TIONinterest
AMT
method.
method.
BEG BV
Rate
EXPENSE PAYMENT
(D/P)
END BV

1/1/2014
6/30/2014
12/31/201
4
6/30/2015
12/31/201
5

$
96,536
$
97,328
$
98,168
$
99,058

6%
6%
6%
6%

$
5,792
$
5,840
$
5,890
$
5,943

$
5,000

$
5,000
$
5,000
$
5,000

792
840
$
890
$
942

$
96,536
$
97,328
$
98,168
$
99,058
$
100,000

Journal Entries for


Interest Expenses
PAR (Stated = Market)
Dr. Interest Expense
$100
Cr. Cash
$100
Premium (Stated >Market)
Dr. Interest Expense
$97
Dr. Premium on Bonds Payable
Cr.
Cash
$100
Discount (Stated<Market)
Dr. Interest Expense
$106
Cr. Discount on Bonds Payable
Cr. Cash
$100

$3

$6