Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 17 Bonds and Long-term Notes Payable

Financial AccountingDave Ludwick, P.Eng, MBA, PMP, PhD

Chapter 17Bonds and Long-term Notes

Payable

In this chapter…Balance Sheet

Current Assets

Cash 10000

Current Liabilities

Accounts Payable

Chapter

5000

Accounts Receivable 20000 Wages Payable 25000

Notes Receivable 15000 Utilities Payable 2000

Marketable Securities 25000 Long-Term Debt

Inventory 120000 Notes Payable 17 20000

Capital Assets Bonds Payable 17 600000

Equipment 250000 Owner’s Equity

Buildings 500000 Common Stock 300000

Goodwill 60000 Retained Earnings

48000

Total Assets 1000000 Total Liabilities + OE 1000000


Bonds• Bonds are a form of debt issued by a company or a

government to raise money. – Usually the organization wishes to raise money to fund R&D,

operations or maybe make capital asset purchases.

• A bond is a written promise to pay an amount identified as the par value of the bond along with interest at a stated annual rate.

• Par value, aka face value is the amount paid at maturity

• Maturity date is the date on which the total bond value amount is due

• Interest rate, or coupon rate is the amount of interest owed, usually quoted as an annual rate, but paid semiannually


Debt vs Equity Financing• As we saw in previous chapters, managers make decision

regarding the best way of raising money:

• Besides selling stock, bonds offer another way:– Bonds do not affect shareholder control as it is debt

• This means existing shareholders may not get upset when new share are issued, thereby diluting their control

– Interest owed on bonds is tax deductible (paid out of before-tax dollars)

• Whereas dividends are paid out of after tax dollars

– Bonds can increase return on equity• Since ROE = Net Income/Common Shareholder’s Equity, as long as

the additional income generated by the bond exceeds interest expense, then ROE has increased


Disadvantages of Bonds• Bonds require payment of both interest and the par value at

maturity. These are debt obligations

• Bonds have a senior claim on assets in the event of a liquidation over owner’s equity

• Just as bonds can increase return on equity, so also can it decrease return on equity if the company does not use the funds well.


Comparing Bonds, Notes & Mortgages• All of these are debt instruments

• Notes:– Notes usually require the payment of interest when the principal is

repaid.

– There is no mid-term interest payments. Full interest is paid when the full principal is repaid

• Bonds:– Bonds require (usually) semi-annual interest payments

– The full bond principal and the last interest payment are due at the end of the life of the bond

• Mortgages– Most mortgages are structured so that a portion of the principal is repaid

on every payment (usually monthly, bi-monthly or bi-weekly)

– The outstanding principal declines over the life of the mortgageFinancial Accounting

Dave Ludwick, P.Eng, MBA, PMP, PhD

Issuing Bonds• When an org issues bonds to raise cash, the journal entry is:

• Bonds are a long-term debt instrument, so they appear on the right side of the balance sheet, below the current liabilities.

• When the organization goes to pay a bond interest payment:

Date Account Titles and explanation PR Debit Credit

Jan 1 Cash 600000

Bonds Payable 600000


Jan 1 Bond Interest Expense 2500

Cash 2500


Issuing Bonds• When the organization pays the bond out:


Jan 1 Bonds Payable 600000

Cash 600000


Bond Pricing• Bonds can be traded on an organized exchange. Bond

prices fluctuate with the prime rate from the Bank of Canada and the international exchange rate.

• As shown in Exhibit 17.3, – if the bond’s interest rate (called a contract rate) is above the

market interest rate, the bond sells at a premium (meaning it sells at a price higher than its par value)

– If the bond’s contract rate is below the market rate, the bond sells at a discount (at a price below its par value)

• We can see the reason why when we look at how to value/price bonds:


Present Value (PV) of a Bond• When someone buys a bond, they see that the bond will

result in a series of interest payments over years, plus an interest payment and the lump sum at the end.

• To calculate how much the bond is worth, we must calculate its present value (that is, how much is this future stream and lump sum worth today).

• Present Value of Bond = PV(Interest Payments) + PV(Maturity Amount)

Interest payment stream

Principal repayment


Present Value of a Bond• PV(Maturity Amount) = Bond Principal x Factor in 17A.1,

where:– Bond Principal = the pay value or face value

– i = interest rate (quoted as an annual rate)

– n = number of payments made over the life of the bond

– You can see this in Table 17A.1 on page 865

• PV(Interest Payments) = Interest Payment x Factor in 17A.2, where:– Interest Payment = Bond Principal x i/(No. of periods in a year)

– i = interest rate (quoted as an annual rate)

– n = number of payments made over the life of the bond

– You can see this in Table 17A.2 on page 865


Valuing a Bond• Example: What is the value of a $100,000 20 year bond, with a coupon

rate of 5%, interest paid semi-annually? Let’s say today’s market interest rate is 6%.

• Present Value of Bond = PV(Coupon Payments) + PV(Maturity Amount)– Coupon Payment = 100000 x .05 / 2 = 2500

– PV(Coupon Payments) = 2500 x Factor from 17A.2 where n=40, i=3%• = 2500 x (P/A, .06/2, 40) = 2500 x 23.1148 = 57787

– PV(Maturity Amount) = 100000 x Factor from 17A.1 where n=40, i=3%• = 100000 x (P/F, .06/2, 40) = 100000 x .3066 = 30660

– Present Value of the Bond = 57787 + 30660 = 88447

• Why is a $100000 only worth $88447?– Because an investor could go to the market and get 6% return, rather than 5%.

– This bond is sold at a discount


Valuing a Bond• Example: What is the value of a $100,000 20 year bond, with a coupon

rate of 5%, interest paid semi-annually? Let’s say today’s market interest rate is 4%.

• Present Value of Bond = PV(Coupon Payments) + PV(Maturity Amount)– Coupon Payment = 100000 x .05 / 2 = 2500

– PV(Coupon Payments) = 2500 x Factor from 17A.2 where n=40, i=2%• = 2500 x (P/A, .04/2, 40) = 2500 x 27.3555 = 68388

– PV(Maturity Amount) = 100000 x Factor from 17A.1 where n=40, i=2%• = 100000 x (P/F, .04/2, 40) = 100000 x .4529 = 45290

– Present Value of the Bond = 68388 + 45290 = 113678

• Why is a $100000 worth $113678?– Because an investor could by the bond and get 5% return rather than only get

4% in the market.

– This bond is sold at a premium


Psst: Wanna a good stock tip?• We can use the same technique to determine the price at which to buy a

stock.

• Scenario: Lets say a your broker calls you up and suggests you should buy a specific stock from him. How do you know it makes sense for you?

• Scenario:– BCE Inc. is selling at $35.70 per share. It pays a quarterly dividend of $0.4925 per

share. The current market interest rate is 4%. You plan to hold the stock for 5 years. Should you buy 100 shares of BCE?

• PV of Stock= PV(Dividend Payments) + PV(Stock price when sold)– If the PV of the stock is greater than its current trading price, we might consider this

purchase


PV of a Stock• When we buy the stock, we would like the stock to be

purchased at a price that is less than the present value of the future cash flows of the stock

• The stock has a few cashflows we should consider– In the future (say 5 years), we may sell the stock. This will

represent a cash inflow

– The quarterly dividends are a cash inflow

– When we buy and sell the stock, we will need to pay brokerage fees, these are cash outflows

– When we sell, we will have to pay taxes (a cash outflow)

Dividend payment stream

Stock sold


Brokerage fee

Taxes

Brokerage fee

Stock purchase

Valuing a Stock• So, again: BCE Inc. is selling at $35.70 per share. It pays a quarterly

dividend of $0.4925 per share. The current market interest rate is 4%. You plan to hold the stock for 5 years. Should you buy 100 shares of BCE?

• We know the dividend and its payment schedule so we can figure out its present value

• We don’t know the price that we will sell the stock at, so we need some additional info to try to forecast the stock price:

– BCE’s current P/E ratio: 13.00

– BCE’s current Earnings per share (EPS): $2.70

• PV(Stock price when sold) must be estimated– Stock price (in 5 yrs) = P/E ratio (in 5 yrs) x EPS (in 5 yrs)

– We could estimate the P/E ratio that we think the stock will be trading at in 5 years by looking at BCE’s P/E history. Lets just say it will be 13

– Also, we could estimate the EPS. There are many models for this which involve a earnings growth rate, but we can take the current EPS as a conservative estimate

– Forecasted stock price = 13 x 2.7 = $35.1 per share


Valuing a Stock• PV of Stock= PV(Dividend Payments) + PV(Stock price when sold)

– Dividend Payment = 100 shares x 0.4925 per share = $49.25 per qtr

– PV(Dividend Payments) = 49.25 x Factor from 17A.2 where n=20, i=1%• = 49.25 x (P/A, .04/4, 5 x 4) = 49.25 x 18.0456 = 888.75

– PV(Stock price when sold) = 100 shares x 35.1 x Factor from 17A.1 where n=20, i=1%

• = 3510 x (P/F, .04/4, 5 x 4) = 3510 x .8195 = 2876.45

– Present Value of the Stock= 888.75 + 2876.45 = 3765.2 (or $37.65 per share)

• Should you buy 100 of BCE?– BCE is currently selling at $35.7. We calculate that the PV of the stock (its

intrinsic value) is $37.62.

– Though the stock is selling slightly less than its “intrinsic value”, we:• Did not factor in brokerage fees on the buy or the sell (they are a small amount if

buying 100 shares, but would lower its intrinsic value)

• We made some assumptions to calculate the selling price of the stock

• Are not sure if we will sell in 5 years – might be before, might be after


Valuing a Stock• Since we have made some estimates and assumptions, we should use a

margin of safety to protect our investment.

• That is, if we value BCE at $37.1, maybe we need to buy at 10% or 20% below this because we can’t be sure of exactly how long we will hold the stock for or what it will be worth when we sell.

• Warren Buffet and Ben Graham (world’s most successful value investors) suggest we use a margin of safety of 50%.

• Do we buy?– Yes, if we don’t use a margin of safety

– No, if we take a margin of safety (currently BCE is only trading 4% below its intrinsic value)

– The longer we hold the stock, the more dividends we’ll get and so the more safety the dividend provides

– Typically, value stocks have EPS which rise over the years. Also, their dividends rise, and so there is some inherent safety because we did not factor these in


Issuing a Bond at a Discount• A Discount on Bonds Payable (a contra-liability on the

balance sheet) occurs when a company issues a bond which has a coupon rate below the market rate– Investors will not want this bond as much because they could get a

higher rate in the market, so the value of the bond drops.

• When the company sells the bonds, the transaction looks like this:


Jan 1 Cash 88447

Discount on Bonds Payable 11553



Issuing a Bond at a Discount• The bond is a long term liability and would be shown as

below on the balance sheetBalance Sheet

Current Assets

Cash 101000

Current Liabilities

AP 750

Accounts Receivable 2000 Wages 1500

Long-term Liabilities


Less: Discount 11553 88447

Inventory 10000 Owner’s Equity 22303



Issuing a Bond at a Premium• A Premium on Bonds Payable (an accretion-liability on the

balance sheet) occurs when a company issues a bond which has a coupon rate higher the market rate– Investors will want to buy this bond up because investing in this

bond would yield more than the market could yield.

• When the company sells the bonds, the transaction looks like this:


Jan 1 Cash 113687

Premium on Bonds Payable 13687



Issuing a Bond at a Premium• Again, the bond is a long term liability and would be

shown as below on the balance sheetBalance Sheet

Current Assets

Cash 126240

Current Liabilities

AP 750

Accounts Receivable 2000 Wages 1500

Inventory 10000 Long-term Liabilities


Add: Premium 13687 113687

Owner’s Equity 22303



Income Statement• Regardless of whether the bond is sold at a premium or

discount, the company needs to pay interest on its borrowings. – The Bond Interest Expense account is shown against the Revenue

for the period

– The Bond Interest Expense account reduces the revenue

Income Statement

Sales Revenue

Expenses

Bond Interest Expense

Net Income

200000

2500

197500


Amortizing a Discount or Premium• In the discount situation, the company will sell a $100,000 but

only get $88447 for it. • Similarly, in a premium situation, the company will sell a

$100,000 but get more than that in cash– It will still need to pay back the full face value of $100000 in 20 years.– It acknowledges this by amortizing the discount and premium. The

payments themselves are still the $2500, but an additional (or reduced) expense is recorded on the income statement to acknowledge the discount

• There are 2 ways to calculate the amortization:– Straight-line Method– Effective Interest Method

• For our purposes, we will not get into these details– Just know how to calculate the interest payments and value the bond

based on the market rateFinancial Accounting

Dave Ludwick, P.Eng, MBA, PMP, PhD

Bond Retirements• Bonds can be retired a number of ways

– They are paid out by cash at maturity

– A company can retire them early by buying them in the open market

– Some bonds have a call option on them: allowing them to be purchased at a stated price

– Some bonds also have a convertible option, allowing them to be converted to shares, at the request of the bond holder.

• The details around these calculations will not be covered.


Other Forms of Debt• Long-term Notes Payable: These are similar to a bond, but

are an agreement between the company and just one lender– Usually these require one repayment with interest

• Installment Notes: These are an obligation to one lender requiring a series of payments. Interest and some portion of principal is repaid in each payment

• Mortgage Notes: Similar to a long-term notes payable, except that the note is made with a contract pledging defined assets in the event of default by the borrower on the note.

• Again, we will not cover the details of these.


Try the Mid-Chapter Demo Problem• Check out the mid-chapter demo problem, do parts 1 and 2


Exercises• Do

– Exercise 17-1

– Exercise 17-2

– Exercise 17-7


Documents

Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 17 Bonds and Long-term Notes Payable