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Chapter F13 Power Notes Bonds Payable and Investments in Bonds Learning Objectives 1. Financing Corporations 2. Characteristics of Bonds Payable 3. The Present-Value Concept and Bonds Payable 4. Accounting for Bonds Payable 5. Bond Sinking Funds 6. Bond Redemption C13 7. Investments in Bonds 8. Corporation Balance Sheet 9. Financial Analysis and Interpretation C13 - 1 Chapter F13 Power Notes Bonds Payable and Investments in Bonds Slide # Power Note Topics 3 • Long-Term Financing 9 • Characteristics of Bonds Payable 17 • Time Value of Money 28 • Issuing Bonds Payable 34 • Redemption of Bonds Payable 35 • Investments in Bonds 36 • Number of Times Interest Earned Note: To select a topic, type the slide # and press Enter. C13 - 2 Two Methods of Long-Term Financing Resources = Sources Liabilities Assets Stockholders’ Equity C13 - 3 Two Methods of Long-Term Financing Resources = Sources Liabilities Assets Stockholders’ Equity Financing – Stockholders Equity C13 - 4 Two Methods of Long-Term Financing Resources = Sources Liabilities Debt Financing – Bondholders Bondholders Assets Stockholders’ Equity Financing – Stockholders Equity C13 - 5 Two Methods of Financing Bondholders Stockholders Why issue bonds rather than stock? Bonds (debt) – Interest payments to bondholders are an expense that reduces taxable income. Stock (equity) – Dividend payments are made from after tax net income and retained earnings. Earnings per share on common stock can often be increased by issuing bonds rather than additional stock. C13 - 6 Alternative Financing Plans – $800,000 Earnings Plan 1 Plan 2 Plan 3 12 % bonds — — $2,000,000 Preferred 9% stock, $50 par — $2,000,000 1,000,000 Common stock, $10 par $4,000,000 2,000,000 1,000,000 Total $4,000,000 $4,000,000 $4,000,000 Earnings before interest and income tax $ 800,000 $ 800,000 $ 800,000 Deduct interest on bonds — — 240,000 Income before income tax $ 800,000 $ 800,000 $ 560,000 Deduct income tax 320,000 320,000 224,000 Net income $ 480,000 $ 480,000 $ 336,000 Dividends on preferred stock — 180,000 90,000 Available for dividends $ 480,000 $ 300,000 $ 246,000 Shares of common stock 400,000 200,000 100,000 Earnings per share $ 1.20 $ 1.50 $ 2.46 C13 - 7 Alternative Financing Plans – $440,000 Earnings Plan 1 Plan 2 Plan 3 12 % bonds — — $2,000,000 Preferred 9% stock, $50 par — $2,000,000 1,000,000 Common stock, $10 par $4,000,000 2,000,000 1,000,000 Total $4,000,000 $4,000,000 $4,000,000 Earnings before interest and income tax $ 440,000 $ 440,000 $ 440,000 Deduct interest on bonds — — 240,000 Income before income tax $ 440,000 $ 440,000 $ 200,000 Deduct income tax 176,000 176,000 80,000 Net income $ 264,000 $ 264,000 $ 120,000 Dividends on preferred stock — 180,000 90,000 Available for dividends $ 264,000 $ 84,000 $ 30,000 Shares of common stock 400,000 200,000 100,000 Earnings per share $ 0.66 $ 0.42 $ 0.30 C13 - 8 Characteristics of Bonds Payable Long-term debt – repayable 10, 20, or 30 years after date of issuance. Issued in face (principal) amounts of $1,000, or multiples of $1,000. Contract interest rate is fixed for term (life) of the bond. Face amount of bond repayable at maturity date. C13 - 9 Bond Variables and Constants 1. Constants – fixed by bond contract. a. Principal (face) amount. b. Contract rate of interest. c. Term (life) of the bond. 2. Variables – determined in the bond market. a. Market price of the bond. b. Market (effective) interest rate. C13 - 10 How are Bond Prices Determined The selling price of bonds are based on two amounts. 1. Present Value of Face Amount The present value of the face amount (constant) of the bond at its maturity date, based on the current market interest rate (variable). 2. Present Value of Interest Payments The present value of the periodic interest payments (constant) for the term of the bonds, based on the current market interest rate (variable). C13 - 11 Market and Contract Interest Rates Differences in market and bond contract interest rates result in Discounts and Premiums. When Bonds sell at Market rate = Contract rate Face value Market rate > Contract rate Discount Market rate < Contract rate Premium C13 - 12 Cash Flow of Bonds Payable On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 13% at date of issue. Cash Outflows: Present Values Interest payments $ 60,000 = $ 43,133 (10 periods at $6,000) Face amount 100,000 = 53,273 (at end of 5 years) $160,000 = $96,403 Cash Inflows: Selling proceeds $ 96,406 = $96,406 C13 - 13 Cash Flow of Bonds Payable On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 13% at date of issue. Cash Outflows: Present Values Interest payments $ 60,000 = $ 43,133 (10 periods at $6,000) Face amount 100,000 = 43,133 Present value of an annuity of $6,000 for (at end of 5 years) 10 periods at a market rate of 6.5% per $160,000 = $96,403 period is $43,133. Cash Inflows: Payment $ = Present $96,403 Selling proceeds x Factor96,403 = Value $6,000 x 7.1888 = $43,133 C13 - 14 Cash Flow of Bonds Payable On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 13% at date of issue. Cash Outflows: Present Values Interest payments $ 60,000 = $ 43,133 (10 periods at $6,000) Face amount 100,000 = 53,273 (at end of 5 years) $160,000 = $96,403 Present value of $100,000 paid at the end Cash Inflows: of 10 six-month periods at a market rate of Selling proceeds $ 96,403 = $96,403 6.5% per period is $53,273. Payment x Factor = Present Value $100,000 x .53273 = $53,273 C13 - 15 Cash Flow of Bonds Payable On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 13% at date of issue. Cash Outflows: Present Values Interest payments $ 60,000 = $ 43,133 (10 periods at $6,000) Face amount 100,000 = 53,273 (at end of 5 years) $160,000 = $96,406 Cash Inflows: Selling price $96,406 C13 - 16 The Time Value of Money – Future Value The time value of money concept is used in many business decisions. This concept is an important consideration in accounting for bonds payable. Present Value $1,000 What is the future value of $1,000 invested today (present value) at 8% per year? Future $ ???? Value C13 - 17 The Time Value of Money – Future Value The time value of money concept is used in many business decisions. This concept is an important consideration in accounting for bonds payable. Present Value $1,000 What is the future value of $1,000 invested today (present value) at 8% per year? Future = $1,000 + ($1,000 x 8%) $1,080 = $1,000 x 108% or 1.08 Value C13 - 18 The Time Value of Money – Present Value The time value of money concept is used in many business decisions. This concept is an important consideration in accounting for bonds payable. Present Value $ ???? What is the present value of $1,000 to be received one year from today at 8% per year? Future $1,000 Value C13 - 19 The Time Value of Money – Present Value The time value of money concept is used in many business decisions. This concept is an important consideration in accounting for bonds payable. Present Value $ 925.93 = $1,000 / 108% or 1.08 What is the present value of $1,000 to be received one year from today at 8% per year? Future $1,000 Value C13 - 20 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 One dollar at the end of one period at 6% per period is equal to $.9434 today (present value). C13 - 21 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 One dollar at the end of two periods at 6% per period is equal to $.8900 today (present value). To use the value from the prior period as the starting point, don’t clear your calculator. C13 - 22 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators, or computers. Present value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 3 .8396 = $ .8900 / 1.06 One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value). C13 - 23 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 3 .8396 = $ .8900 / 1.06 4 .7921 = $ .8396 / 1.06 5 a calculator,$learn to /use constant division. When using .7432 = .7921 1.06 and .7432 / first You will then enter $1 = $ 1.06 the1.06 time, pressing 6 .7050 only the equal (=) key for each successive answer. C13 - 24 Calculating Present Values of Annuities Annuities represent a series of equal amounts to be paid or received in the future over equal periods. Present value of $1 — Annuity of $1 PV Table Annuity Calculation Period 6% 6% Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 .8396 2.6730 = to be 3 The PV of an annuity of $1Periods 1–3 .7921 year for = years is 4 received each 3.4651 twoPeriods 1–4 of the PV of 5 $1.8334. This is the sum = Periods 1–5 .7432 4.2124 the two amounts for periods 1 and 2. 4.2124 C13 - 25 Calculating Present Values of Annuities Annuities represent a series of equal amounts to be paid or received in the future over equal periods. Present value of $1 — Annuity of 1$ PV Table Annuity Calculation Period 6% 6% Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 3 .8396 2.6730 = Periods 1–3 .7921 3.4651 = to be 4 The PV of an annuity of $1Periods 1–4 .7432 year for = Periods is 5 received each 4.2124 three years 1–5 $2.6730. This is the sum of the PV of 4.2124 the three amounts for periods 1–3. C13 - 26 Calculating Present Values of Annuities Annuities represent a series of equal amounts to be paid or received in the future over equal periods. Present value of $1 — Annuity of 1$ PV Table Annuity Calculation Period 6% 6% Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 3 .8396 2.6730 = Periods 1–3 4 .7921 3.4651 = Periods 1–4 5 .7473 4.2124 = Periods 1–5 Total 4.2124 C13 - 27 Bonds Issued at Face Amount On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 12% at date of issue. Date Description Debit Credit Jan. 1 Cash 100,000 Bonds Payable 100,000 Issued 12%, five-year bonds at face. PV of face due in 5 years ($100,000 x 0.55840) = $55,840 PV of $1 for 10 periods at 6% PV of 10 interest payments ($6,000 x 7.36009) = 44,160 PV of annuity of $1 for 10 periods at 6% Total selling price = $100,000 C13 - 28 Bonds Issued at a Discount On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 13% at date of issue. Date Description Debit Credit Jan. 1 Cash 96,406 Discount on Bonds Payable 3,594 Bonds Payable 100,000 Issued 12%, five-year bonds at a discount. PV of face due in 5 years ($100,000 x 0.53273) = $53,273 (PV of $1 for 10 periods at 6.5%) PV of 10 interest payments ($6,000 x 7.18883) = $43,133 (PV of annuity of $1 for 10 periods at 6.5%) Total selling price = $96,406 C13 - 29 Amortization of a Bond Discount The straight-line method amortizes bond discount in equal periodic amounts. Date Description Debit Credit Jan. 1 Cash 96,406 Discount on Bonds Payable 3,594 Bonds Payable 100,000 Issued 12%, five-year bonds at a discount. Jun. 30 Interest Expense 6,359.70 Discount on Bonds Payable 359.70 Cash 6,000.00 Payment of semiannual interest and amortization of 1/10 of bond discount. C13 - 30 Bonds Issued at a Premium On January 1, $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually are issued. Market rate is 11% at date of issue. Date Description Debit Credit Jan. 1 Cash 103,769 Bonds Payable 100,000 Premium on Bonds Payable 3,769 Issued 12%, five-year bonds at a premium. PV of face due in 5 years ($100,000 x 0.58543) = $ 58,543 (PV of $1 for 10 periods at 5.5%) PV of 10 interest payments ($6,000 x 7.53763) = 45,226 (PV of annuity of $1 for 10 periods at 5.5%) Total PV (selling price) = $103,769 C13 - 31 Amortization of a Bond Premium The straight-line method amortizes bond premium in equal periodic amounts. Date Description Debit Credit Jan. 1 Cash 103,769 Bonds Payable 100,000 Premium on Bonds Payable 3,769 Issued 12%, five-year bonds at a premium. Jun. 30 Interest Expense 5,623.10 Premium on Bonds Payable 376.90 Cash 6,000.00 Payment of semiannual interest and amortization of 1/10 of bond premium. C13 - 32 Zero-Coupon Bonds Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity. Assume market rate is 13% at date of issue. Date Description Debit Credit Jan. 1 Cash 53,273 Discount on Bonds Payable 46,727 Bonds Payable 100,000 Issued $100,000 five-year zero-coupon bonds. PV of face due in 5 years ($100,000 x 0.53273) = $53,273 (PV of $1 for 10 periods at 6.5%) An investment of $53,273 today would yield $100,000 in five years compounded semiannually at 6.5%. C13 - 33 Bond Redemption A corporation may call or redeem its bonds before they mature. Assume a bond issue of $100,000 and an unamortized premium of $4,000. Carrying value is $96,000 and one-fourth of the bonds are purchased. Date Description Debit Credit Jun. 30 Bonds Payable 25,000 Premium on Bonds Payable 1,000 Gain on Redemption of Bonds 2,000 Cash 24,000 Redeemed one-fourth of the total bonds. C13 - 34 Investments in Bonds Bonds are purchased directly from the issuing corporation or through an organized bond exchange. Bond prices are quoted as a percentage of the face amount. Date Description Debit Credit Apr. 2 Investment in Bonds 1,025.30 Interest Revenue 10.20 Cash 1,035.50 Purchased a $1,000 bond at 102 plus a brokerage fee of $5.30 and accrued interest of $10.20 Investors do not usually record premium (or discount) in separate accounts because bonds are not often held until maturity. C13 - 35 Solvency Measures — The Long-Term Creditor Number of Times Interest Charges Earned 2003 2002 Income before income tax $ 900,000 $ 800,000 Add interest expense 300,000 250,000 Amount available for interest $1,200,000 $1,050,000 C13 - 36 Solvency Measures — The Long-Term Creditor Number of Times Interest Charges Earned 2003 2002 Income before income tax $ 900,000 $ 800,000 Add interest expense 300,000 250,000 Amount available for interest $1,200,000 $1,050,000 Number of times earned 4.0 times 4.2 times Use: To assess the risk to debtholders in terms of number of times interest charges were earned. C13 - 37 Chapter F13 Power Notes Bonds Payable and Investments in Bonds This is the last slide in Chapter F13. Note: To see the topic slide, type 2 and press Enter. C13 - 38

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