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LEVERAGE
Income from Debt > Interest on Debt
Debt Pros:
Fixed Payments to Lenders
If Rising Inflation: $ Today < $ Tomorrow
Debt Cons:
Inflexible Payment Schedules Bankruptcy
Bond Terms
What are Bonds?
Large Debt in Small Chunks ($1K)
Too Large for Single Lender
Face Value = Par Value = Principal
Paid at Maturity (Typical)
Monthly (Sometimes)
Lender
s
Value
Terms
Traded
Regula
r
Payme
nts
Secure
d
One
Vary
Vary
No
Principal
and
Interest
Yes
Bond
Many
$1,000/each
5+ Years
Yes
Interest
Yes and No
Selling Bonds
Why?
No Effect on Company
Ownership/Management
No Dilution of Shares
Interest vs. Dividends
Underwriters (Sellers)
Determine Market Rate for Bond
Assume Risk of Bonds from Issuer (Buy)
Resell Bonds (Sell)
PAR:
Stated =Market
DISCOUNT: Stated<
=IP IE
Market< IP IE
Interest
Payment
$10,000
Interest
Payment
$10,000
Face Value:
$100,000
Due: 4 Years
Stated Rate: 10%
Interest
Payment
$10,000
Interest
Payment
$10,000
Maturity
$100,000
Market
Market rate
rate of
of 12%
12%
22 interest
interest periods
periods per
per year
year
=
= 6%
6%
Bond
Bond term
term of
of 22 years
years
22 periods
periods per
per year
year =
= 44
periods
periods
Bonds Issued at ?
Finally,
determine
the issue
price of the
bond.
Market
Market rate
rate of
of 8%
8%
22 interest
interest periods
periods per
per year
year
=
= 4%
4%
Bond
Bond term
term of
of 22 years
years
22 periods
periods per
per year
year =
= 44
periods
periods
Market
Market rate
rate of
of 8%
8%
22 interest
interest periods
periods per
per year
year
=
= 4%
4%
Bond
Bond term
term of
of 22 years
years
22 periods
periods per
per year
year =
= 44
periods
periods
The
premium
will be
amortized
over the 2year life of
the bonds.
Journal Entries
At Issue
$3K
Discount/Premium Accounts
PREMIUM ON BONDS PAYABLE
Adjunct-Liability
Amortization Methods
Amortization = Amount of Interest Payment +Disc
(Prem) Expensed over Time
METHODS
Straight Line
Equal amounts over time
Not GAAP (Except @ PAR)
Effective Interest
Market Rate x BV of Bonds(Beg of Period)
Similar to Compound Interest Calculations
GAAP
Straight-Line Method
AMOUNT OF
PREMIUM or DISCOUNT
=DISCOUNT/PREMIU
# of PERIODS
M AMORTIZED PER
PERIOD(DA/PA)
(FACE VALUE x STATED RATE)
Plus: Discount Amortization Amt.
Less: Premium Amortization Amt.
INTEREST EXPENSE
STRAIGHT-LINE MATRIX
BEG
DATE BV
CONSTANT
AMORTIZA
INTEREST TION AMT
EXPENSE
D(P)
(PREM or
DISC)/
B+D
PERIODS
CONSTANT CONSTANT
INTEREST
PAYMENT
FV x STATED
RATE
END BV
A+B
AT&T
AT&T issued
issued $100K
$100K bonds
bonds on
on Jan.
Jan. 1,
1, 2014.
2014.
The
The bonds
bonds sold
sold for
for $96,536.
$96,536. The
The bonds
bonds
have
have aa 2-year
2-year maturity
maturity and
and $5,000
$5,000
interest
interest is
is paid
paid semiannually.
semiannually.
DATE
1/1/2014
6/30/2014
Compute
Compute the
the periodic
periodic discount
discount
amortization
amortization using
using the
the straight-line
straight-line
method.
A
B method.
C
D
BEG BV
$
96,536
$
12/31/2014 97,402
$
6/30/2015
98,268
INTERES
T
AMORTIZAT
PAYMEN INTEREST ION AMT
T
EXPENSE
(D/P)
END BV
$
96,536
$
$
$
$
5,000
5,866
866
97,402
$
$
$
$
5,000
5,866
866
98,268
$
$
$
$
5,000
5,866
866
99,134
$3
$6
A
B
C
D
E
F
DAT BEG
E
BV
MARKET
(YIELD)
INTEREST
EXPENSE
INTEREST
PAYMENT
(A x B)
BV x
MARKET
CONSTANT
FV x STATED
RATE
CONSTANT
AMORTIZATI
ON AMT
END
(PA/DA)
BV
(A+E
(C-D)
)
AT&T
AT&T issued
issued $100K
$100K bonds
bonds on
on Jan.
Jan. 1,
1, 2014.
2014.
The
The bonds
bonds sold
sold for
for $96,536.
$96,536. The
The bonds
bonds
have
have aa 2-year
2-year maturity
maturity and
and $5,000
$5,000
interest
interest is
is paid
paid semiannually.
semiannually. The
The stated
stated
rate
rate on
on the
the bonds
bonds is
is 10%.
10%. The
The market
market
rate
rate at
at the
the time
time the
the bonds
bonds were
were sold
sold was
was
12%
12%
DATE
A
B the periodic
C
D discount
E
F
Compute
Compute
the periodic
discount
AMORTIZA
amortization
using
the
effective
interest
amortization
using
the
effective
Market
INTEREST INTEREST TIONinterest
AMT
method.
method.
BEG BV
Rate
EXPENSE PAYMENT
(D/P)
END BV
1/1/2014
6/30/2014
12/31/201
4
6/30/2015
12/31/201
5
$
96,536
$
97,328
$
98,168
$
99,058
6%
6%
6%
6%
$
5,792
$
5,840
$
5,890
$
5,943
$
5,000
$
5,000
$
5,000
$
5,000
792
840
$
890
$
942
$
96,536
$
97,328
$
98,168
$
99,058
$
100,000
$3
$6