AC221 Libby & Short Ch. 10~Solutions~

AC221 Libby & Short Ch. 10~Solutions~ - Chapter 10...

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Chapter 10 - Reporting and Interpreting Bonds Chapter 10 Reporting and Interpreting Bonds ANSWERS TO QUESTIONS 1. A bond is a liability that may or may not be secured by a mortgage on specified assets. Bonds usually are in denominations of $1,000 or $10,000, are transferable by endorsement, and may be bought and sold daily by investors. A bond specifies a maturity date and rate of interest that will be paid on the principal amount. Bonds usually are issued to obtain cash for long-term asset acquisitions (operational assets) and expansion of the entity. 2. A bond indenture is an agreement drawn up by a company planning to sell a bond issue. The indenture specifies the legal provisions of the bond issue such as maturity date, rate of interest, date of interest payments, and any conversion privileges. When a bond is sold, an investor receives a bond certificate (i.e., a bond). All of the bond certificates for a single bond issue are identical in most respects. That is, each certificate states the same maturity date, interest rate, interest dates, and other provisions of the bond issue. 3. Secured bonds are supported by a mortgage or pledge of specific assets as a guarantee of payment. Secured bonds are designated on the basis of the type of asset pledged, such as real estate mortgage bonds and equipment trust bonds. Unsecured bonds are not supported by a mortgage or pledge of specific assets as a guarantee of payment at maturity date. Unsecured bonds usually are called debentures. 10-1
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Chapter 10 - Reporting and Interpreting Bonds 4. Callable bonds—bonds that may be called for early retirement at the option of the issuer. Convertible bonds—bonds that may be converted to other securities of the issuer (usually common stock) after a specified future date at the option of the bondholder. 5. Several important advantages of bonds compared with capital stock benefit the issuer. The issuance of bonds establishes a fixed amount of liability and a fixed rate of interest on the bond, and interest payments to the bondholders are deductible on the income tax return of the issuer. This deduction for tax purposes reduces the net cost of borrowing. For example, a corporation with a 40% average tax rate and bonds payable with a 10% interest rate would incur a net interest rate of 10% x 60% = 6%. 6. The higher the tax rate is, the lower the net cost of borrowing money because the interest paid on borrowed money is deductible on the income tax return of the borrower. The higher the income tax rate the less the net cost of interest for the borrower. For example, a corporation with an average tax rate of 40% and debt with 10% interest per annum incurs a net interest rate of 10% x 60% = 6%. In contrast, the same corporation with a 20% average tax rate incurs a net interest rate of 10% x 80% = 8%. 7.
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This note was uploaded on 02/22/2012 for the course AC 221 taught by Professor Albuquerque during the Fall '08 term at BU.

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AC221 Libby & Short Ch. 10~Solutions~ - Chapter 10...

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