Accounting 201 - Lecture A10 Notes

Material is getting harder, so it's crucial to keep up.
No make-ups will be given for the final exam.
Exam 2 cursory reviews will be held during lab class office hours from Monday (4/7) through Wednesday (4/9). Make arrangements with small section teachers.

When a company needs cash, it has three main sources:
- Generate profits from selling goods and services, which increases Retained Earnings (Internal source).
- Sell shares of ownership in the company by issuing stock (Equity financing - External source).
- Borrow money by issuing debt; a common type is issuing bonds (Debt financing - External source).

Advantages of issuing bonds over additional shares of capital stock:
1. Expansion is achieved without giving up ownership control.
2. Interest payments are tax-deductible, unlike dividend payments.
Disadvantages of issuing bonds:
1. Increased risk of bankruptcy.
2. Potential reduction in financial flexibility due to restrictive debt covenants.

It's important to understand the time value of money before accounting for bonds.
Example: Considering a 10% annual return, which is better: $100 today or $105 in one year?
$100 today will grow to $110 in one year with a 10% interest rate. Therefore, $100 today is better.
$105 one year from now is worth less than $100 today because money loses value over time.

Consider retirement planning as an example.
Investing $1,000 today into stocks, assuming an average historical return of 11%:
- After 45 years (retirement at age 65): $109,530
- This shows the effect of compound interest.
What if $1,000 is invested each year (annuity payment):
- After 45 years: $986,639
- Demonstrates the effect of compound interest on regular investments.

Present value is the opposite of future value.
Future value: What will be the future value of today’s amount?
Present value: What is the value today of some future amount?
Example: $1,000 in three years, with $10\%$ compounding annually. The present value is calculated as:
- Present Value = $1,331 {\times} {0.75131} = $1,000

Instead of a single future amount, determine the present value of multiple future amounts (annuity).
Example: Receiving $1,000 each year for the next three years, with a discount rate of $10\%$ .
- Present value of three $1,000 annual payments = $1,000 {\times} {2.48685} = $2,487
Present value has important applications in business decisions like investing, budgeting, capital expenditures, and compensation.

Deposited $6,000 in a savings account earning $10\%$ interest for ten years:
- FV = $6,000 {\times} {2.59374} = $15,562.44
Purchasing a delivery truck with $50,000 due in three years, at $10\%$ . What is the cost of the truck today?
- PV = $50,000 {\times} {0.75131} = $37,565.50
Establishing a fund to retire $30,000 of debt in ten years by depositing $2,000 per year at $9\%$ . Is it enough to pay the debt?
- FVA = $2,000 {\times} {15.1929} = $30,385.80
Renting an office. Option 1 = $25,000 today. Option 2 = $10,000 at the end of each year for three years at $10\%$ . Which option is better?
- Option 2: PVA = $10,000 {\times} {2.48685} = $24,868.50 (Better)

When a company needs cash, it can issue bonds.
Individuals pay cash, and the company promises to return cash via:
1. Periodic interest payments.
2. The principal amount at the end of the bond’s life.
Example: Issue a $1,000,000, $10\%$ semi-annual, three-year bond.
- Semi-annual interest payment = $1,000,000 {\times} {10 \%} {\times} {\frac{6}{12}}
- Final principal payment = $1,000,000
- Total cash paid = $1,300,000

A company issues a $1,000,000, $10\%$ semi-annual, 3-year bond for $950,826.
Journal entry:
- Debit Cash $950,826
- Credit Bonds Payable $950,826
Accounting equation:
- Assets increase by $950,826
- Liabilities increase by $950,826