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MDC ACG 2071 - Bonds Payable and Investment in Bonds

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ACG 2071Module 1: Bonds Payable and Investment in BondsCorporations use debt to purchase asset for use. Many products are generally purchased through credit such as accounts payable and notes payable. Bonds – o a form of interest bearing note.o -requires periodic interest payments and the face amount must be repaid at the maturity date.o bondholders are creditors of the issuing corporation.Corporations need to decide how to acquire cash for operations. They have several methodsIssue common or preferred stock or bothIssue bondsOr any combination of theseExample 1: A company needs to acquire $5,000,000 for an expansion project. They have the following options:Plan 1 Plan2 Plan3Issue 12% bonds $3,000,000Issue 9% preferred stock, par $50$2,500,000Issue common stock , $10 par$2,000,000 $2,500,000 $5,000,000If the corporation expects to earn $500,000 annually with a tax rate of 30%, whatis the effect of the three plans on net income?Plan 1 Plan 2 Plan 3Earnings before taxes $500,000 $500,000 $500,000Less interest on bonds $240,000 -0- -0-Income before taxes $160,000 $500,000 $500,000Less income taxes $48,000 $150,000 $150,000Created by M. MariFall, 2007Page 1 of 12ACG 2071Module 1: Bonds Payable and Investment in BondsIncome after taxes $112,000 $350,000 $350,000Dividends on preferred stock $225,000Available for dividends on common stock$112,000 $125,000 $350,000Earnings per share (EPS) $0.56 $0.50 $0.70Common stock shares 200,000 250,000 500,000Because the earnings are not high enough to cover preferred dividends or bond interest, selling common shares of stock would have the least effect on EPS.If the income was higher then bonds become more viable.Characteristics of BondsBond indenture – contract that the corporation issues with the bondBond issue is divided into a number of individual bondsPrincipal – face value of each bondInterest – payable annually, semiannually, or quarterlyPrice of bond – quoted as a percentage of the bonds’ face value.Types of bondso Term bonds – all are due at the same timeo Serial bonds – parts of the bond issue become due at different dateso Convertible bonds – may be exchanged for stocko Callable bonds – can be redeemed before maturity dateo Debenture bonds – based on general credit of the corporationPricing of BondsPrice of the bond depends ono Face amount of the bonds Identified in the bond indenture along with the interest rateo Periodic interest to be paid on the bonds called the contract rate or coupon rate Periodic interest is expressed as a percentage of the face amount of the bondsCreated by M. MariFall, 2007Page 2 of 12ACG 2071Module 1: Bonds Payable and Investment in Bondso The market rate of interest called effective rate of interest Depends on a variety of factorsInterest rate Market price of bondMarket rate = coupon rate Face ValueMarket rate > coupon rate Premium – price above face Caused because buyers cannot betterreturn elsewhereMarket rate < coupon rate Discount – price below face Caused because buyers can getbetter return on other instruments.How is Price Computed?The face amount of the bonds and the periodic interest on the bonds represent cash to be received by the buyer in the futureBuyer determines how much to pay for the bonds by computing the present value of these future cash receipts, using market rate of interestPresent value = called time value of moneyTime value of MoneyWhat is the value of $100 in one year if your earn 10% on your money?o $100 x 10% = $10o So $100 earning 10% in one year is $110.o Therefore, the present value of $110 is $100.Therefore, when talking about bonds, the present value is how much the face that we will receive in the future is worth today given the market rate of interest. Present value of the Face of the BondBelow is the present value tables that are used to compute the present value of the face of the bond.Present value interest factor of $1 per period at i% for n periods, PVIF(i,n).Period 5% 5.50% 6.00% 6.50% 7% 10% 11% 12% 13% 14%1 0.95238 0.94787 0.94340 0.93897 0.93458 0.90909 0.90090 0.89286 0.88496 0.877192 0.90703 0.89845 0.89000 0.88166 0.87344 0.82645 0.81162 0.79719 0.78315 0.769473 0.86384 0.85161 0.83962 0.82785 0.81630 0.75131 0.73119 0.71178 0.69305 0.674974 0.82270 0.80722 0.79209 0.77732 0.76290 0.68301 0.65873 0.63552 0.61332 0.592085 0.78353 0.76513 0.74726 0.72988 0.71299 0.62092 0.59345 0.56743 0.54276 0.519376 0.74622 0.72525 0.70496 0.68533 0.66634 0.56447 0.53464 0.50663 0.48032 0.455597 0.71068 0.68744 0.66506 0.64351 0.62275 0.51316 0.48166 0.45235 0.42506 0.399648 0.67684 0.65160 0.62741 0.60423 0.58201 0.46651 0.43393 0.40388 0.37616 0.35056Created by M. MariFall, 2007Page 3 of 12ACG 2071Module 1: Bonds Payable and Investment in Bonds9 0.64461 0.61763 0.59190 0.56735 0.54393 0.42410 0.39092 0.36061 0.33288 0.3075110 0.61391 0.58543 0.55839 0.53273 0.50835 0.38554 0.35218 0.32197 0.29459 0.26974Present value of the Periodic Bond Interest PaymentsThe present value of periodic bond interest payments is the value today of the amount of interest paid over the life of the bond. A series of equal cash payments at fixed intervals is called an annuity.The present value of an annuity is the sum of the present values of each cash flow.Example: Suppose that the interest rate is 5% and you are to receive three payments of $100 per year over the next three years. What is the value today of these payments?$94.88$89.85$85.16$269.89Easier way is to use the Present Value of Annuity tablePresent value interest factor of an (ordinary) annuity of $1 per period at i% for n periods, PVIFA(i,n).Period 5.00% 5.50% 6.00% 6.50% 7.00% 10.00% 11.00% 12.00% 13.00% 14.00%1 0.95238 0.94787 0.94340 0.93897 0.93458 0.90909 0.90090 0.89286 0.88496 0.877192 1.85941 1.84632 1.83339 1.82063 1.80802 1.73554 1.71252 1.69005 1.66810 1.646663 2.72325 2.69793 2.67301 2.64848 2.62432 2.48685 2.44371 2.40183 2.36115 2.321634 3.54595 3.50515 3.46511 3.42580 3.38721 3.16987 3.10245 3.03735 2.97447 2.913715 4.32948 4.27028 4.21236 4.15568 4.10020 3.79079 3.69590 3.60478 3.51723 3.433086 5.07569 4.99553 4.91732 4.84101 4.76654 4.35526 4.23054 4.11141 3.99755 3.888677 5.78637 5.68297 5.58238 5.48452 5.38929 4.86842 4.71220 4.56376 4.42261 4.28830Created by M. MariFall, 2007Page 4 of 12Today Year 1 Year 2 Year 3Receive $100Receive $100Receive $100$100 X 0.94787$100 X 0.89845$100 X 0.85161ACG 2071Module 1: Bonds Payable and Investment


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