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# Chapter 10 Notes ACC 211

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This 7 page Class Notes was uploaded by ec on Wednesday August 26, 2015. The Class Notes belongs to ACC 211 at University of Miami taught by Sicre in Summer 2015. Since its upload, it has received 40 views.

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Date Created: 08/26/15

Study Guide Exam 3 FINAL Chapter 812 11232013 Croonenberghs Emilie 1 Characteristics of Bonds Payable 0 Introduction a Capital Structure a mixture of debt and equity a company uses to nance its operations Almost ALL companies employ some debt in their capital structure Debt is NOT a bad thing When larger corporations or governmental agencies need to borrow raise large sums of cash they usually issue bonds b Bonds are securities issued both by corporations and governmental units Bonds have liquidity as they are able to be purchased and sold in a secondary market It provides the creditor purchaser of bond an outlet if they should ever decide to get rid of the bond It is an important advantage for the issuing corporations since shorterterm loans usually are accompanied by a lower interest rate 0 Bonds Payable Both stocks and bonds are issued by corporations to raise cash for longterm purposes a Advantages of Bond there are several reasons why a corporation would rather issue a bond that stock Stockholder s maintain control Interest Expense is taxdeductible Impact on earnings is positive b Disadvantages of Bond there are several disadvantages to issuing a bond Risk of bankruptcy Negative impact on cash ows 0 Terms a Bond Principle the amount that is payable at the maturity date and on which the periodic cash interest payments are calculated b Par ValueFace Value another name for bond principle or the maturity amount of that bond c Stated Rate the interest rate paid by the bond ol Secured assets are pledged as a guarantee of repayment at maturity e Unsecured Debenture no assets are pledged as a guarantee of repayment at maturity f Callable bond may be recalled for early retirement at the option of theissuer g Convertible may be converted to other securities of the issuer usually common stock h Bond lndenture this is the bond contract which speci es the legal provisions of the bond Which include Maturity Date Interest Rate to be paid Date of Interest Payments Conversions Privileges Covenants designed to protect the creditors 393 Limitation of payments of dividends 393 Limitation on new debt oz Minimum accounting ratios Bond covenants are typically reported in the notes to the nancial statements i Bon Certi cate the bond document that each bondholder receives j Trustee an independent party which is appointed to represent the interest of the bondholders and ensure that the bond issuer complies with all provisions of the bond indenture Given that bonds can be complex there are several agencies which evaluate the probability that a bond issuer will not be able to meet the requirements speci ed in the indenture It is called quotdefault riskquot 0 Issue Ratings The evaluating agencies issue ratings to specify the quality of a bond These ratings drive the interest rate costs of the bonds a Issuing the issuing company DOES NOT determine the price at which bonds will sell The market determines the prices using the present value concepts b Market Interest Rate Yield or EffectiveInterest Rate is the current rate of interest on a debt when incurred Creditors demand a certain rate of interest to compensate them for the risks related to bonds 0 Reporting Bonds a Coupon Rate is the stated rate of interest on bonds b Bond Premium is the difference between the selling price and par when the bond is sold for more than par Less than 10 c Bond Par is when the selling price and par when the bond is sold for EXACTLY the same par Exactly 10 d Bond Discount is the difference between the selling price and par when the bond is sold for less than par More than 10 0 Key Points a Constant the interest payment remains constant no matter what happens to the market rate b Bond Prices bond prices and market rate prices have an inverse relationship If the market rate increases the bond price decreases and x If the market rate decreases the bond price increases 2 Reporting Bond Transactions Bonds Issued at Par a Issued at Par bonds sell at par when buyers are willing to invest in them at the interest rate stated in the bond contract For example 100000 bond sold for 100000 Face rate is same as the market rate 10 semiannual payments The interest expense is 5000 b Interest Expense is reported on the income statement Since it is related to nancing activities NOT operating activities it is normally not included in operating expenses It is reported as a deduction from quotoperating incomequot c Time Interest Earned Ratio the times interest earned The ratio shows the amount of resources generated for each dollar of interest expense Time Intera Interest Expense Income Tax Interest Expense 9 l IIIgII LIIIIEb IIILEIEbL EdIIIEU IdLIU lb VIEWEU IIIUIE IdVUIdUIy than a low one 0 Bonds Issued at a Discount a Issued at a Discount bonds sell at a discount when the market rate of interest is higher than the stated interest rate on them For example 100000 bond sold for 100000 Face rate i510 and market rate is 12 semiannual payments maturing in two years oz Since price of a bond moves in an quotinversequot relationship price will be lower at a discount b Calculate Price at a Discount to calculate the prince you need the annuity amount 5000 and the factors PV of single sum 6 for 4 periods PV of an Annuity 6 for 4 periods c Interest Expense to adjust interest expense the borrower amortizes the bond discount each period as an increase in interest expense The amount of the discount is amortized over the remaining periods of the bond straightline amortization 0 Reporting Interest Expense Using StraightLine Amortization a StraightLine Amortization is a simpli ed method of amortizing a bond discount or premium that allocates an equal dollar amount to each interest period There is an amortization schedule which will help i Interest to be Paid x 10000 x 12 ii Interest Expense a b iii Amortization discount 4 periods iv Book Value Beginning Book Value Amortization 0 Reporting Interest Expense Using EffectiveInterest Amortization a EffectiveInterest Amortization is a method of amortizing a bond discount or premium on the basis of the effectiveinterest rate it is the theoretically preferred method Interest expense for a bond is computer by multiplying the current unpaid balance times the market rate of interest that existed on the date bonds were sold The periodic amortization of a bond premium or discount is then calculated as the difference between interest expense and the amount of cash paid or accrued b Calculate EffectiveInterest Amortization there is two steps to calculate Step 1 Compute Interest Expense Interest Ex e se 391 U palld Balance X Effective lnterestXat 1i 393 n number of months in each interest period Step 2 Computer Amortization Amount Amo h t Amou qlf raeosth mgnsaaf nitJnterest Interest to be paid 100000 x 10 x 12 Interest Expense 12 x Beginning of Period Book Value x 12 Amortization b a Book Value Beginning Book Value c 0 Zero Coupon Bonds a Zero Coupon Bonds a corporation might issue a bond that does not pay periodic cash interest This type of bond is simply a deeply discounted bond that will sell for substantially less than its maturity value When you compute the Present Value PV you simply use the factor for the Single Sum and do not include an Annuity Factor since there are no interest payments 3 Early Retirement of Debt Bonds Issued at a Premium a Issued at a Premium bonds sell at a premium when the market rate of interest is lower than their stated interest rate 100000 bond sold for 100000 Face rate is 10 lower and market rate 8 semiannual payments matures in two years 393 Price of a bond moves in an inverse relationship price will be higher sold at a premium b Calculate at a Premium to calculate the price you need the annuity amount and the factors PV of single sum 4 for 4 periods PV an annuity 4 for 4 periods c Recording Bonds the premium is recorded in a separate contra liability account as credit The bonds payable account is credited for the par amount and the premium is recorded as a credit to Premium on Bonds Payable 0 Reporting Interest Expense Using StraightLine Amortization a Interest Expense to adjust the interest expense the borrower amortizes the bond premium each period as a decrease in interest expense The amount of the premium is amortized over the remaining periods of the bond b StraightLine Amortization is a simpli ed method of amortizing a bond discount or premium that allocates an equal dollar amount to each interest period There is an amortization schedule which will help i Interest to be paid 100000 x 10 x 12 ii Interest Expense Interest to be paid amortization iii Amortization discount 4 periods iv Book Value Beginning Book Value Amortization 0 Reporting Interest Expense Using EffectiveInterest Amortization a Interest Expense under the effectiveinterest amortization method interest expense for a bond is computed by multiplying the current unpaid balance times the market rate of interest that existed on the date the bonds were sold The periodic amortization of a bond premium or discount is then calculated as the difference between interest expense and the amount of cash paid or accrued b EffectiveInterest Amortization the effectiveinterest amortization method is basically the same for a discount or premium There are two steps to compute the amortization Step 1 Compute Interest Expense Interest Ex e se 391 U pigd Balance X Effective lnterestXah 1i 393 n number of months in each interest period Step 2 Compute amortization amount Amo h Amou liglgrest Expense Cash Interest d Amortization Schedule bond premium effectiveinterest Interest to be paid 10 x 100000 x 12 Interest Expense 8 x Beginning of Period Book Value x 12 Amortization b a Book Value Beginning Book Value c DebtToEquity Ratio a DebttoEquity measure of a company s nancial leverage A high ratio suggest that the company relies heavily on funds provided by creditors DebttoEquity Total Liabilities Stockholder s Equity

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