Financial 5 - BONDS

Question 1

Stated Interest vs Effective Interest: Rates and Payments

Answer 1

Stated Interest

• Interest Paid / Value of the Bond = Stated Interest Rate

Effective Interest

• GAAP Interest Expense / CV at beginning of the period = Effective Interest Rate

Question 2

Bond Types

Answer 2

Term Bonds - have a single fixed maturity date

Bond Sinking Fund - a fund that a company contributes cash to each period so that it has enough to pay off the bond at maturity

Debentures - unsecured corporate bonds

Serial Bonds - bonds that are pre-numbered that the issuer may call and redeem a portion by a serial number. They mature in installments

Question 3

Bond Valuation at Issuance

Answer 3

Bond Issue costs reduce the cash received from the bond issuance and are deducted from the carrying value of the bond liability

EX:
- if the Bond is issued at a premium, the issuance costs will net against the premium and be credited along with the bond liability

• if the Bond is issued at a discount, the issuance cost will add to the discount (debit) to drive the carrying value of the bond down (cash received will decrease consequently)

** Factor in the issuance cost to the premium or discount before determining cash received or bond liability

• • The market value of a bond issued at a discount or premium is the PV of 2 cash flows:
    1. PV of Principal Amount (PV of $1 * Principal)
    2. PV of future interest payments (PV of Ordinary Annuity * Interest Payment)
    3. Both of these at the market (effective) rate of interest

Question 4

Balance Sheet Reporting of Bonds

Answer 4

RULE: Bond Liability is shown net of discount on the BS

Question 5

Issuance Costs and Warrants

Answer 5

RULE: All costs associated with the issuance of bonds should be amortized over the “outstanding” term of the bonds

Examples: Promotion costs,engraving and printing, underwriters’ commissions

Detachable Stock Warrants

• The issue price of the bonds and warrants together should be allocated based on each component’s fair values on the issuance date. If the warrants FV is known, the value assigned to the warrants is equal to their fair value as a stand alone investment

** Bond Fair Value - FV of Warrants = Residual is allocated to the Bonds