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6. Bonds and Leases

# 6. Bonds and Leases - Bonds and Leases What are Bonds A...

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1 Bonds and Leases What are Bonds? A Certificate to Show Evidence of Debt. The Issuer of the Bonds Makes Two Promises: 1. To Make Periodic Interest Payments, and 2. To Pay Back the Face Value (see below) at Maturity . Terminology Face Value or Par Value = The nominal amount (dollar amount) Due at maturity. Coupon Rate or Stated Rate of Interest = the Amount of Interest Payable in One Year Divided by the Principal Amount. The Coupon Rate Determines What the Bond Issuer Pays in Cash Interest Payments . Effective Rate (or Market Rate” ) = Yield to Maturity of a Bond. It is the Actual Rate of Interest the Borrower Will Incur.

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2 Compare Effective Rate with Coupon Rate : If the bond is issued for a price Below Par Value , then the Effective Rate > the Coupon Rate . Think Intuitively ... If an investor is getting a coupon cash rate from a Bond of 8% , but the Effective/Market Rate is 10% (the investor can go down the street and earn 10%), why would the investor buy those bonds? Only if she can get the bonds at a Discount . Similarly, if the bond is issued for a price above face value, then the Effective Rate is Below the Coupon Rate. If an Investor is Getting a Cash Coupon Payment of 11%, and the Effective Rate is 9% , then the Investor Will Pay a Premium for that privilege.
3 Proceeds of a Bond Issue - Issuer Pays Interest Periodically & Repays the Principal at Maturity. Bonds Issued at Par: Example: Xavier Co. issues \$100,000 face value of 12% Semi-Annual Coupon Bonds on July 1, 20X1. Xavier must repay the debt 5 years Later On July 1, 20X6. Interest payments are due on July 1st & January 1st of each year. The Coupon Payments Are: \$6,000 = \$100,000 *.12 * 6/12 Assume the Market Rate of interest is exactly 12% compounded semi-annually.

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4 The Time-Line below represents the Cash Flows for Xavier: +100,000 -100,000 -6000 -6000 -6000 -6000 -6000 -6000 -6000 -6000 -6000 -6000 / / / / / / / / / / / 1/1/X2 1/1/X3 1/1/X4 1/1/X5 1/1/X6 7/1/X1 7/1/X2 7/1/X3 7/1/X4 7/1/X5 7/1/X6 The Proceeds of the Bonds Are (= the Present Value of What the Issuer Pays): (i) Present value of \$100,000 Principal to be paid in 5 years: PV of \$1 table, 10 periods at 6% , because the bond is semi-annual, or (100,000)(.55839) = 55,839 (ii) Present value of \$6,000, to be paid every 6 months for 5 years: PV of annuity in arrears, 10 periods at 6% , or (6000)(7.36009) = 44,161 TOTAL PROCEEDS \$100,000 Journal Entry: Cash \$100,000 Bonds Payable \$100,000
5 Bonds Issued at Less than Par -

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