Bond Fundamentals and Valuation

Long-Term Liability – Bonds

• Bonds are long-term debt owed to multiple lenders (bondholders).
• Bonds are issued through an underwriter (intermediary).

Bond Terminology

• Principal: Face, maturity, or par value.
• Maturity date: Debt repayment date.
• Stated interest rate (Coupon rate): Interest rate stated in the bond certificate, determining interest payments, usually semiannual.
• Market interest rate (Effective interest rate): Rate of return demanded by bondholders; may differ from the stated rate.
• Market price: Reflects the present value of future cash flows; can be higher (premium) or lower (discount) than face value.

Bond Premiums and Discounts

• Premium: Market price above face value.
  • Stated interest rate > market rate.
• Discount: Market price below face value.
  • Stated interest rate < market rate.
• Market price converges to par value as maturity approaches.

Bond Prices

• Quoted as a percentage of maturity value.
  • Example: Bond X, par value $1,000.
  • Quoted at 100: Price is $1,000 (at par).
  • Quoted at 101.5: Price is $1,015 (premium).
  • Quoted at 97.5: Price is $975 (discount).

Bond Issuance Journal Entries

• At par ($1,000):
  • Debit Cash $1,000, Credit Bonds Payable $1,000.
• At a premium ($1,015):
  • Debit Cash $1,015, Credit Premium on Bonds Payable $15, Credit Bonds Payable $1,000.
• At a discount ($975):
  • Debit Cash $975, Debit Discount on Bonds Payable $25, Credit Bonds Payable $1,000.

Present Value (Price) of a Bond

• Determined by the present value of future cash flows:
  • Payment of face value at maturity.
  • Periodic interest payments (annuity).
• Market price is the sum of these present values.

Time Value of Money

• Money loses value over time due to potential earnings.
• Compound interest: Earning interest on interest.
• Future Value Formula for n years: 1,000 x (1 + .10)^n

Future Value

• Single Amount: Value of an investment at a future date with compound interest.
• Annuity: Series of equal payments made over a period.

Present Value

• Opposite of future value; value today of a future amount.

Present Value Calculation

• Discount rate reflects the time value of money.

Bond Pricing Components

• Present value of the principal repayment at maturity.
• Present value of the stream of future interest payments (annuity).
• Sum these to find the bond's issuance price.

Bond Pricing Example

• To calculate the bond price at issuance:
  • PV of principle = 100,000 x 0.676 = $67,600
  • PV of interest payments = 100,000 x 5\% x 8.111 = $40,555
  • Bond price at issuance = 67,600 + $40,555 = $108,155

Measuring Bond Interest

• Interest Payable = Face value * Stated interest rate * Fraction of the year outstanding
• Effective-Interest Method: Interest Expense = Carrying value * Market interest rate * Fraction of the year
• Carrying Value = Face value – Discount balance (after amortization) OR Face value + Premium balance (after amortization)

Bond Interest Example – Discount

• Issuance: Debit Cash and Discount on Bond Payable; Credit Bond Payable.
• Interest Payment: Interest Expense = Carrying value * Market interest rate.
• Discount Amortization: Difference between interest expense and interest payable.

Bond Interest Example – Premium

• Issuance: Debit Cash; Credit Premium on Bond Payable and Bond Payable.
• Interest Payment: Interest Expense = Carrying value * Market interest rate.
• Premium Amortization: Difference between interest payable and interest expense.

Interest Expense Calculation

• Interest Payable = Face value * Stated rate * Time fraction
• Interest Expense = Carrying value * Market rate * Time fraction

Bond Discount Amortization

• Amortization table shows periodic interest, expense, and discount amortization.

Bond Premium Amortization

• Amortization table shows periodic interest, expense, and premium amortization.

Retiring Bonds Before Maturity

• Reasons: To relieve high interest payments or borrow at lower rates.
• Methods:
  • Purchase bonds in the open market.
  • Exercise call option (if available): Issuer pays face value plus a call premium.
• May result in a gain or loss reported on the income statement.

Early Retirement Calculation

• If Carrying value of bond > cash paid = gain.
• If Carrying value of bond < cash paid = loss.

Convertible Bonds

• Bondholders can exchange bonds for common stock.
• Increases stockholders’ equity upon conversion.

Accounting Equation Effect of Convertible Bonds

\text{Assets} = \text{Liabilities} + \text{Stockholders’ Equity}

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Ratio Analysis

• Debt ratio: Total debt (liabilities) / Total assets.
• Leverage ratio: Total assets / Total stockholders' equity.
• Time-Interest-Earned Ratio (Interest Coverage Ratio) = Operating Income / Interest Expense
  • Measures a company's ability to cover interest obligations.