Long-term Liabilities

1© Copyrright Doug Hillman 2000

Long-termLiabilities


Bonds

Written promise to pay a specific sum of money on a speciific future date

Purchaser is bondholder Receives Bond certificate


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


Bonds Compared to Stock

Bondholders are creditors

Bonds a liability Interest is fixed charge

Interest is expense Interest tax deductible

No voting

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


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


Why Bonds Sell at Discount or Premium

When market interest rate on comparable grade bonds is higher or lower than the stated rate,



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



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



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



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


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)


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


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


Issuance of Bonds

Increase Cash for the proceeds of issuance

Increase Bonds Payable for face value Increase Premium or Discount for the

difference


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


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


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


Discount Amortization Example

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


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


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


Discount Amortization Effective Interest


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


Premium Amortization Example

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


Premium Amortization Straight-Line


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


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


Premium Amortization Effective Interest


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


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


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


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


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?

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Long-term Liabilities