Handouts_Bonds Review

Handouts_Bonds Review - -* " J.L. KELLOGC GRADUATE...

Info iconThis preview shows pages 1–7. Sign up to view the full content.

View Full Document Right Arrow Icon
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 2
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 4
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 6
Background image of page 7
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: -* " J.L. KELLOGC GRADUATE SCHOOL or :uxaczmr NORTHWESTERN UNIVERSITY -;. - ,_ - ___ Prof B.V Balachandr‘ BONDS ' - ; ......... --.. " -- - __ ._ I.: s“‘;’;':.. ' --":" .,_ . . EL“ . . This announcement IS neither an offer 10 sell nor a sahcxlcmon at an offer la buy these securities. -‘ -?:- Thea’ferismadeonlybylheProsoecm. 32:55: - -_... -- - o- . .-...----- / NEW ISSUE . Jonuaryd.1982 riis'ggmaboo' i. OLE MANUFACTURING CORPORATION ' ‘ ‘_'.'. I ‘__- . - 3 $74 10% Converlible Subordinaled Debeniures Due 2006 ~ 70 ac. , / I! A . g .. . .The Debewses aieconvelane inlo CamrncnvSlock atany lime priodo malmty. unless areal , _ i I cusly redeemed. al a rate. subject lo adjustment under cencin candilions. of 533.06 pa sncre. l l l l l l l .;-_-_'_.,---prsce.400% -- (Plus accrued interest ll any, Ram January's, 1982) which this annomcemenl is cilculaled only from such at the r _ ; , undetsigned as may legally Offer these securities in such Slate. . . l l I ,1 Copies of the Prospectus may be ablainea in any Slale in ' l gjpomscmw. UNTERBERG. low-lain _ Egan. STEARN§§LCOVM“ l CD UngngFI‘J'K/J r mamm- \. .\ [A] Bond contracts are long-term debt instruments (contracts) which contain a predetermined (fiXed) repayment schedule. The contract obligates the bond issuer (e.g. Bally Company) to make certain cash payments at specific future dates to the bond holder (e.g. an individual, company, or institutional investor) in exchange for a "negotiated" cash payment (i.e. iSSue price) from the bond holder at the time of issuance. The stated (coupon) interest rate coupled with the maturity (face) value of the 55nd spec1fy the periodic cash payments to be received by the bond holder. For example, a "$10,0000, five- year, 8 percent bond paying annual interest“ is shorthand for the following cash payment schedule: Tear: ‘ 0 i 2 ' 3 4 5 Cash Issue $800 $800 $800 $800 $800 "interest" Flow:" $10,000 'principal' Bonds may be issued (placed) privately or publicly; however, only public placements are actively traded in the bond narket. Investment banking firms (e.g. Salomon Brothers) act as brokers for both private and public placements. The advertisment above is typical of "new issue" offers. Note that the “advertised” price is expressed as a percent of the face value of the bond; e.g. an asking price of '100' means that the company hopes to receive 100 'percent of the face value at the date of issue. Interest Rate Fluctuations and Bond Prices — [B] One unique feature of a bond contract is that the “return” (i.e. cash flows to‘ the bond holder) is predetermined and is independent of the-issue price.--For - -~~~" example, an investor holding the bond outlined in {A} above will receive $800 per year for five years and $10,000 at the end of the fifth year regardless of the price at which the bond is issued. At what price will the bond be issued? The price an investor is willing to- pay for a bond, and the effective interest rate or return the investor demands from that bond, are jointly determined by the risk/return characteristics of the investor's opportunity set and the investor's perceptions about the - inherent risk of the bond. Since the cash flows free holding the bond are fixed, the only way an investor can alter the effective interest rate (1.e. real return) on the bond is by paying more (or less) than the face value of the bond. To illustrate, consider an investor who is willing to accept a 'real return” of 6-percent on the bond described in [A]. Apparently this investor's‘ opportunity set is limited to alternative investment projects which pay about 6-percent on a risk-adjusted basis. .In order to earn a 6-percent return on the bond, the investor must purchase the bond (at the beginning of year 1) for a price not in excess of: $10,0000 x .747 (Table l for 62, 5 yrs) - $7,470.00 $301 x 4.212 (Table 2 for 61, 5 yrs) ‘ 3,369.60 Price: $10,839.60 n the other hand, an investor who demands a lO-percent real return on the p'inyestment (perhaps because the investor views the bond and company as particularly risky), would be unwilling to pay a price in excess of: $10,000 3 .621 (Table l for 101, 5 yrs) 3 $6210.00 $800 x 3.791 (Table 2 for 102, 5 yrs) - 3032.80 Price: $9242.80 ' It should cone as no surprise, then, that'tfie market price of a bond,(either at the date of issuance or at subsequent dates) is influenced by changes in the prevailing market interest rate (T-bill rates, for example), and by changes in the 'riskiness' of the company (likelihood of default on the bond). when the aarket interest rate increases (decreases), the market price for all outstanding bonds decreases (increases) since the bonds become relatively less (more) attractive when compared with other forms of invtstmeut. [C] Bend Covenants The bond issuer frequently adds “restrictive covenants' or clauses to the bend contract whereby the issuer voluntarily agrees ts refrain frea certain actiens (e.g. issuing additional debt or paying dividends to shareholders). the ' notivation for these cevenants is relatively straightforward. By agreeing ts limit payments to shareholders and to restrict nee debt issues, the cempany is - providing the investor with an added margin of safety (i.e. making the bond ' less risky). In exchange for agreeing to restrict its activities, the company hopes to receive a higher issue price (i.e. lower effective interest rate) than would other be the case. - For~exaaple,-J.P. Stevens £ Co. issued $30,000,000 of convertible subordinated debentures in October of 1978. The offered issue price was 101; however the proceeds to the company amounted to $9 and 3/4. Although the debt was not Secured, the company agreed: (a) to maintain a debt/equity ratio less than or equal to 1/2; and (b) to “not pay cash dividends or acquire any stock if the total payments would exceed consolidated net earnings after Oct. 31 1964 plus $25,000,000 and net proceeds froa sales of stock after said date.“ [DI Accounting for Bond Issues At iSSuance, the bond is recorded at the issue price (proceeds) which represents the present value of the liability as of the issue date discounted at the effective (market) interest rate applicable to the bond. Transactions costs are capitalized and amortized over the life of the bond. If the issue price exceeds the face value of the bond, the bond is said to have been issued at a “premium”; conversly, if the issue price is less than Eh! face value of the bond, the bond is said to have been issued at a 413Count'. Any difference between issue price and face value (i.e. the 1“1‘1'1 Premium er discount) is amortized over the life of the bond. Consequently:_(i) the bookvalue of the bond at the date of issuance equals the ' issue price of the bond; (ii) the bookvalue of the bond immediately prior to the maturity date equals the face value of the bond; (iii) the bookvalue of the bond between issue and maturity dates gradually approaches the face value of the bond as a result of amortizing the initial discountfor premium. Anortization and Interest Expense ’ The amount of discount (or premium) amortization and the amount of interest expense to be recorded in each period are codeternined using one of two GAAP methods. 6 finder the “straight-line" method, the amortization is given by: ‘ discount Amortization - or x (l/n) where a e number of interest periods premium interest expense is given by: + discoant amortization_ ‘ or Expense = cash interest paynent l " p - premium amortization ,- 7- Under the "effective interest" method»“interest'expense'in each'period is " ”"' "mi7 '”' given by: 1 hookvaiue of the . Expense - ‘hond at the begin. 3 (effective interest rate) of the period ‘ - The appropriate anortization is given by: Amortization 8 cash interest payment ~ interest expense Rote that if the bond is issued at a premium (discount), the cash interest payment will always be greater (less) than the interest expense for the period. Retirement . At retirement, interest expense to date Bust be recorded and then the difference between the cost to retire (i.e. cash paid to retire the bond) and the bookvalue of the bond at time of retirement is recorded as a gain or loss. Special problems arise when an outstanding bond is retired by issuing a new bond (“rollover”) or by 155°13S 5t°Ck' Acfie Corporation is attempting to issue a 510.0000 ten-year pond with a scmi‘annual coupon rate of 5-percent that pays interest oq June 30 and_ __ December,3l.i—An_iqvestor, Jane;$mith, is willing to buy;tbe boqg at a price which yields at least 8-percent semi-annually. The maximum price Smith is yilling to pay: :u:;;j: : 3 :vff‘_:‘ . 5500 x 9.818 (Table 2 for 81, 20 periods) - ' 4,909.00 . .. -. —— __ ;gaax.,Pr_1ce_:_ $7,059.00 at $10,000 x”".'215“("fa'b1e 1 to} 82,. ‘20 pe.r1§51_s) 'TZT,'_I'5'.0‘.00 ‘3';~' -:: :{Etesent;yalue of;the bond at 52 gemi-anqpaikx;qarket-:ate Acme accepts Smitfifls bid and.issues the bond on Januaty11, 1979, and makes the following journal entries.fon l979npnder the “effective interest_nethod': 1/1179: . Cash ' $7,059.00 ' Bond Payable $7,059.00 , . . . 055 Si 93..-: 6/30/79: Inter.th kpensef $564.72 5: .3 : ; . :: Cash $500.00 Bond Payab1e** ‘ 64.72 .-— -.,_.- -., - ‘H... ,..- , _- .?".-‘.-...-._ .-,‘.....‘d..."-.-, ,‘q. . -.-... . ---.- ..-.—. 2 99;-r*-50;93§.§:7059.00 x .03. . :-:';" T’--2 : ;;'. ; ** "discount anortizatioa‘ ' " ' lookvaiue of the bond: $7059.00 + 64.72 12/31/79 interest Expense* $569.90 ' 11:5: 9835 "' .1. 55: H : $500.00 399d Payable ;= 69.90 ~*.$69.90 { (7059.00 + 04.72)_x ,QB ~3:5:- -. ** 'discount amortization' Bookvalue of the bond:3 $7,059.00 + 64.72 + 69.90 I I I o l . m»... In Early Retirement 1980 the market (effective) interest rate had risen Suppose that by January 1, market price of the bond would be: to 102 (semi-annually). The current $10,000 1 .180 (Table 1 for nor, 18 periods) - $ 1,800.00 $500 x 8.203 (wale 2 for P02, 18 periods) - 6,100.50 Price: $ 5,900.50 end on January 1, 1980 is $7,193.62. Suppose the bond by repurchasing it directly from the market. The ded as follows (ignoring transactions costs): The bookvalue of the b conpany retires the old retirement would_be recor 1/1/80: ’Bond Payable $7,193.62 Gain on Retirement $1,293.12 Cash 5,900.50 moreover, assume the company immediately reissued the old bond at the prevailing market price: Cash ' $5,900.12 5 1/1/80 Send l’ayable 4 $5,900.12, iS'the‘coapany "better" or ‘worse' off 35"“ Ignoring income tax considerations; 'rollover' debt in a result of these'two transactions? Why-would a company this manner? To continue with our illustration, the following entries would be uade during 1980: a 6/30/80 Interest Expense* $590.05 Cash $500.00 Bond Payable 90.05 * $5,900.05 x .10 (new effective interest rate) 12/31/80 Interest Expense* $599.06=~ Cash $500.00 99.06 Bond Payable t ($5,900.50 + 90.05) x .19 ~ . (ZED ;'50L€flchat the lOZ_g§fective interest rate is used in 1980 only because the bond had been retired and reissued. In the absence of the January 1, 1980 gxansactions, Acme would continue to account for the bond using the original effective interest rate of 81. . - ra.._ K 1'- . Issues for Further Consideration (1) Suppose Jane Smith faced an entirely different set of investment opportunities’back in January of 1979, and was willing to purchase the Acme bond at a price which would yield at least £2 semi-annually. verify that the issue price in this case would be $11,355.00. Provide all Acne Co. journal entries for 1979 related to-the bond. . (2} what purpose do the 'Discount on Bonds Payable” and “Premium on Bonds Payable" balance sheet accounts serve? (3) Suppose Acme Company had used the 'straight-line‘ method to account for the bond. How would this method alter the journal entries (and by implication, the'ffihancial statements) for 1979? (4) Prepare journal entries to account for the bond during 1979 from the -perspective of a bond holder (e.g. Jane Saith) a. M‘ -_.-u-- -- ...
View Full Document

Page1 / 7

Handouts_Bonds Review - -* " J.L. KELLOGC GRADUATE...

This preview shows document pages 1 - 7. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online