Chapter 13 Lecture and Notes

Explain the Pricing of Long-Term Liabilities

When additional long-term funding needs arise, a business can choose to sell stock in the company (equity-based financing) or obtain a long-term liability (debt-based financing). Long-term liabilities are obligations that are expected to be paid after one year.

Types of long-term debt financing:

• Loans
  • Typically money borrowed from a bank or other lender
• Bonds
  • Sold to investors who become creditors of the company

 

Loans

• A company signs what is known as a note.
• A legal relationship called a note payable is created between the borrower and the lender.
• The document lists the conditions of the financial arrangement, such as:
  • a fixed predetermined interest rate (or, if the agreement allows, a variable interest rate)
  • the amount borrowed
  • the borrowing costs to be charged
  • the timing and make-up of the payments
• Payment typically includes principal and interest.
• In some cases, companies will secure an interest-only loan, which means that for the life of the loan, the organization pays only the interest expense that has accrued and upon maturity repays the original amount that it borrowed and still owes.

 

Promissory Note. A personal loan agreement is a formal contract between a lender and borrower. The document lists the conditions of the loan, including the amount borrowed, the borrowing costs to be charged, and the timing of the payments.

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Introduction to Bonds

Bonds are a form of interest-bearing notes payable. It is a type of financial instrument that a company issues directly to investors, bypassing banks or other lending institutions.

• It contains a promise to pay the investor two things—a specified rate of interest over a specified period of time, plus the principal at a specified date.
• When a company borrows money by selling bonds, it is said the company is “issuing” bonds.
• The bond indenture is the formal legal document, a bond certificate, between the issuer (business) and the lender (investor) and specifies the following:
  • Principal (also called face value or maturity value): amount that will be repaid in the future
  • Maturity date: the day the bondholder will receive the principal
  • Stated interest rate (also called coupon rate): the rate of interest the issuer (the business) agrees to pay the bondholder over the life of the bond. The issuer commits to paying a stated interest rate either once a year (annually) or twice a year (semiannually). It is important to understand that the stated rate will not go up or down over the life of the bond.
• Bonds are typically issued in relatively small denominations, such as $1,000, so they can be placed in the market and are accessible to a greater market of investors compared to notes.

 

  

 

 

Features of Bonds

Bond contracts can contain different features or be of differing types:

• A debenture is an unsecured bond issued based on the good name and reputation of the company; no assets are pledged to back the loan.
• A secured bond is the opposite of a debenture, meaning the company is pledging a specific asset as collateral for the bond.
• A term bond, or single-payment bond, is one where the entire bond will be repaid all at once, rather than in a series of payments.
• A serial bond matures over a period of time and will be repaid in a series of payments.
• A callable bond(also known as a redeemable bond) is one that can be repurchased or “called” by the issuer of the bond.
• A putable bond gives the bondholder the right to decide whether to sell it back early or keep it until it matures. It is essentially the opposite of a callable bond.
• A convertible bond can be converted to common stock in a one-way, one-time conversion.

 

Pricing Bonds

• Bondholders can sell their bonds on national exchanges. 
  
• Bond prices—the amount for which they sell—are based on the length of time to maturity, the risk associated with the bond, the overall economy, geopolitical factors, and strength of the dollar. All of these factors affect the supply and demand of the bonds.
  • Market rate of interest (also called yield or effective rate): the interest rate determined by all of the above; basically, the return demanded by the investors (bondholders) in order to make them willing to buy the bond
• Bond prices are quoted in percentages. If a bond with a maturity value of $1,000 is selling at 0.98, this means it is selling at 98% of face value or $980. Thus, the bond sold at a discount of $20.
• Bonds selling at 1.00 will sell at par value, which is 100% of face value. In the case of a $1,000 bond, the bond would sell for $1,000.
• Bonds selling at a premium will sell for more than 100% of face value. For example, a $1,000 bond selling at $1.20 will sell for 120% of face value at $1,200.

 

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Calculating Interest

It is a function of three factors:

1. Principal (amount borrowed)
2. Length of time 
3. Rate of interest

Interest Rate = Annual Rate $\div$ payments per period

Interest in Dollars = Principal X Interest Rate X Time

Type of Interest

Simple interest earns money only on the principal. 

Compound Interest. Compound interest earns money on the principal plus interest earned in a previous period. 

 

Here is an interesting video exemplifying the difference between simple and compound interest

 

 

How to calculate simple and compound interest

 

Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method

 

Example: Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on December 31, 2019. The terms provide for annual installment payments of $50,926 (not including real estate taxes and insurance).

 

• Amortization is the process of separating the principal and interest in the loan payments over the life of a loan.
  • It is the same as depreciation, but applied to intangible assets.
• When bonds are amortized, the premium, or discount, if one exists, is included in the amortization process.
  • Discounts increase interest expense.
  • Premiums decrease interest expense.
• Two methods of bond amortization:
  • Straight-line: interest expense (including discount or premium amortization) the same each accounting period
  • Effective-interest: interest expense (including discount or premium amortization) based on the carrying value of the bonds and, therefore, changes each accounting period

 

Loan Amortization

 

 

Bond Amortization

 

 

Prepare Journal Entries to Reflect the Life Cycle of Bonds

 

 

Journalizing Issuing Bonds

 

Journalizing Redeeming Bonds

 

 

Financial Presentation of Bonds

  

 

 

 

Appendix: Special Topics Related to Long-Term Liabilities

Debt financing means borrowing money that will be repaid on a specific date in the future. Many companies have started by incurring debt.

• The company is required to make timely interest payments to the holders of the bonds or notes payable.
• The interest in cash that is to be paid by the company is generally locked in at the agreed-upon rate, and thus the same dollar payments will be made over the life of the bond. Virtually all bonds will have a maturity point. When the bond matures, the maturity value, which was the same as the contract or issuance value, is paid to whoever owns the bond.
• The interest paid is deductible on the company’s income tax return.
• Bonds or notes payable do not dilute the company’s ownership interest. The holders of the long-term liabilities do not have an ownership interest.
• Bonds are typically sold in $1,000 increments.

 

Equity financing is when a business owner sells part of the business to obtain money to finance business operations. With this type of financing, the original owner gives up some portion of ownership in the company in return for cash.

• For a corporation, equity financing involves trading or selling shares of stock in the business to raise funds to run the business.
• The main benefit of financing with equity is that the business owner is not required to pay back the invested funds, so revenue can be re-invested in the company’s growth.
• Companies funded this way are also more likely to succeed through their initial years.
• The Small Business Administration suggests a new business should have access to enough cash to operate for six months without having to borrow.
• Unlike bonds that mature, common stocks do not have a definite life. To convert the stock to cash, some of the shares must be sold.
• The disadvantages of this funding method are that someone else owns part of the business and, depending on the arrangement, may have ideas that conflict with the original owner’s ideas but that cannot be disregarded.

 

• Businesses can obtain financing (cash) through profitable operations, issuing (selling) debt, and by selling ownership (equity).
• Notes payable and bonds payable are specific types of debt that businesses issue in order to generate financial capital.
• A bond indenture is a legal document containing the principal amount, maturity date, stated interest rate, and other requirements of the bond issuer.
• Periodic interest payments are based on the amount borrowed, the interest rate, and the time period for which interest is calculated.
• Bond selling prices are determined by the market interest rate at the time of the sale and the stated interest rate of the bond.
• Bonds can be sold at face value, at a premium, or at a discount.
• The effective-interest method is a common method used to calculate the interest expense for a given interest payment.
• There is an inverse relationship between the price of a bond and the market interest rate.
• The carrying value of a bond sold at a discount will increase during the life of a bond until the maturity or face value is reached.
• The carrying value of a bond sold at a premium will decrease during the life of a bond until the maturity or face value is reached.
• Journal entries are recorded at various stages of a bond, including when the bond is issued, for periodic interest payments, and for payment of the bond at maturity.
• Interest expense associated with a bond interest payment is calculated by the bond’s carrying or book value multiplied by the market interest rate.