Transcript Organizational Behaviour Course 5587WI2

Chapter 17
Bonds and Long-term Notes
Payable
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
In this chapter…
Balance Sheet
Current Assets
Cash
Current Liabilities
Chapter
10000
Accounts Payable
Accounts Receivable
20000
Wages Payable
Notes Receivable
15000
Utilities Payable
Marketable Securities
25000 Long-Term Debt
Inventory
120000
Capital Assets
20000
Bonds Payable
17
600000
Buildings
500000
Total Assets
2000
17
250000 Owner’s Equity
60000
25000
Notes Payable
Equipment
Goodwill
5000
Common Stock
300000
Retained Earnings
48000
1000000 Total Liabilities + OE
1000000
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Bonds
• Bonds are a form of debt issued by a company or a
government to raise money.
– Usually the organization wishes to raise money to fund R&D,
operations or maybe make capital asset purchases.
• A bond is a written promise to pay an amount identified as
the par value of the bond along with interest at a stated
annual rate.
• Par value, aka face value is the amount paid at maturity
• Maturity date is the date on which the total bond value
amount is due
• Interest rate, or coupon rate is the amount of interest owed,
usually quoted as an annual rate, but paid semiannually
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Debt vs Equity Financing
• As we saw in previous chapters, managers make decision
regarding the best way of raising money:
• Besides selling stock, bonds offer another way:
– Bonds do not affect shareholder control as it is debt
• This means existing shareholders may not get upset when new share
are issued, thereby diluting their control
– Interest owed on bonds is tax deductible (paid out of before-tax
dollars)
• Whereas dividends are paid out of after tax dollars
– Bonds can increase return on equity
• Since ROE = Net Income/Common Shareholder’s Equity, as long as
the additional income generated by the bond exceeds interest expense,
then ROE has increased
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Disadvantages of Bonds
• Bonds require payment of both interest and the par value at
maturity. These are debt obligations
• Bonds have a senior claim on assets in the event of a
liquidation over owner’s equity
• Just as bonds can increase return on equity, so also can it
decrease return on equity if the company does not use the
funds well.
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Comparing Bonds, Notes & Mortgages
• All of these are debt instruments
• Notes:
– Notes usually require the payment of interest when the principal is repaid.
– There is no mid-term interest payments. Full interest is paid when the full
principal is repaid
• Bonds:
– Bonds require (usually) semi-annual interest payments
– The full bond principal and the last interest payment are due at the end of
the life of the bond
• Mortgages
– Most mortgages are structured so that a portion of the principal is repaid
on every payment (usually monthly, bi-monthly or bi-weekly)
– The outstanding principal declines over the life of the mortgage
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Issuing Bonds
• When an org issues bonds to raise cash, the journal entry is:
Date
Account Titles and explanation
Jan 1
Cash
PR
Debit
Credit
600000
Bonds Payable
600000
• Bonds are a long-term debt instrument, so they appear on the
right side of the balance sheet, below the current liabilities.
• When the organization goes to pay a bond interest payment:
Date
Account Titles and explanation
Jan 1
Bond Interest Expense
PR
Cash
Debit
Credit
2500
2500
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Issuing Bonds
• When the organization pays the bond out:
Date
Account Titles and explanation
Jan 1
Bonds Payable
PR
Debit
Credit
600000
Cash
600000
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Bond Pricing
• Bonds can be traded on an organized exchange. Bond
prices fluctuate with the prime rate from the Bank of
Canada and the international exchange rate.
• As shown in Exhibit 17.3,
– if the bond’s interest rate (called a contract rate) is above the
market interest rate, the bond sells at a premium (meaning it sells
at a price higher than its par value)
– If the bond’s contract rate is below the market rate, the bond sells
at a discount (at a price below its par value)
• We can see the reason why when we look at how to
value/price bonds:
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Present Value (PV) of a Bond
• When someone buys a bond, they see that the bond will
result in a series of interest payments over years, plus an
Principal
interest payment and the lump sum at the end.
repayment
Interest payment stream
• To calculate how much the bond is worth, we must
calculate its present value (that is, how much is this future
stream and lump sum worth today).
• Present Value of Bond = PV(Interest Payments) +
PV(Maturity Amount)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Present Value of a Bond
• PV(Maturity Amount) = Bond Principal x Factor in 17A.1,
where:
–
–
–
–
Bond Principal = the pay value or face value
i = interest rate (quoted as an annual rate)
n = number of payments made over the life of the bond
You can see this in Table 17A.1 on page 865
• PV(Interest Payments) = Interest Payment x Factor in 17A.2,
where:
–
–
–
–
Interest Payment = Bond Principal x i/(No. of periods in a year)
i = interest rate (quoted as an annual rate)
n = number of payments made over the life of the bond
You can see this in Table 17A.2 on page 865
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Valuing a Bond
• Example: What is the value of a $100,000 20 year bond, with a coupon
rate of 5%, interest paid semi-annually? Let’s say today’s market interest
rate is 6%.
• Present Value of Bond = PV(Coupon Payments) + PV(Maturity Amount)
– Coupon Payment = 100000 x .05 / 2 = 2500
– PV(Coupon Payments) = 2500 x Factor from 17A.2 where n=40, i=3%
• = 2500 x (P/A, .06/2, 40) = 2500 x 23.1148 = 57787
– PV(Maturity Amount) = 100000 x Factor from 17A.1 where n=40, i=3%
• = 100000 x (P/F, .06/2, 40) = 100000 x .3066 = 30660
– Present Value of the Bond = 57787 + 30660 = 88447
• Why is a $100000 only worth $88447?
– Because an investor could go to the market and get 6% return, rather than 5%.
– This bond is sold at a discount
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Valuing a Bond
• Example: What is the value of a $100,000 20 year bond, with a coupon
rate of 5%, interest paid semi-annually? Let’s say today’s market interest
rate is 4%.
• Present Value of Bond = PV(Coupon Payments) + PV(Maturity Amount)
– Coupon Payment = 100000 x .05 / 2 = 2500
– PV(Coupon Payments) = 2500 x Factor from 17A.2 where n=40, i=2%
• = 2500 x (P/A, .04/2, 40) = 2500 x 27.3555 = 68388
– PV(Maturity Amount) = 100000 x Factor from 17A.1 where n=40, i=2%
• = 100000 x (P/F, .04/2, 40) = 100000 x .4529 = 45290
– Present Value of the Bond = 68388 + 45290 = 113678
• Why is a $100000 worth $113678?
– Because an investor could by the bond and get 5% return rather than only get
4% in the market.
– This bond is sold at a premium
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Psst: Wanna a good stock tip?
• We can use the same technique to determine the price at which to buy a
stock.
• Scenario: Lets say a your broker calls you up and suggests you should buy
a specific stock from him. How do you know it makes sense for you?
• Scenario:
– BCE Inc. is selling at $35.70 per share. It pays a quarterly dividend of $0.4925 per
share. The current market interest rate is 4%. You plan to hold the stock for 5 years.
Should you buy 100 shares of BCE?
• PV of Stock= PV(Dividend Payments) + PV(Stock price when sold)
– If the PV of the stock is greater than its current trading price, we might consider this
purchase
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
PV of a Stock
Stock sold
• When we buy the stock, we would like the stock to be
purchased at a price that is less than the present value of
the future cash flows of the stock
Dividend payment stream
Brokerage fee
Brokerage fee
• The stock has a few cashflows we should consider
– In the future (say 5 years), we may sell the stock. This will
represent a cash inflow
Stock purchase
– The quarterly dividends are a cash inflow
– When we buy and sell the stock, we will need to pay brokerage
fees, these are cash outflows
– When we sell, we will have to pay taxes (a cash outflow)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Taxes
Valuing a Stock
• So, again: BCE Inc. is selling at $35.70 per share. It pays a quarterly
dividend of $0.4925 per share. The current market interest rate is 4%. You
plan to hold the stock for 5 years. Should you buy 100 shares of BCE?
• We know the dividend and its payment schedule so we can figure out its
present value
• We don’t know the price that we will sell the stock at, so we need some
additional info to try to forecast the stock price:
– BCE’s current P/E ratio: 13.00
– BCE’s current Earnings per share (EPS): $2.70
• PV(Stock price when sold) must be estimated
– Stock price (in 5 yrs) = P/E ratio (in 5 yrs) x EPS (in 5 yrs)
– We could estimate the P/E ratio that we think the stock will be trading at in 5 years by
looking at BCE’s P/E history. Lets just say it will be 13
– Also, we could estimate the EPS. There are many models for this which involve a
earnings growth rate, but we can take the current EPS as a conservative estimate
– Forecasted stock price = 13 x 2.7 = $35.1 per share
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Valuing a Stock
• PV of Stock= PV(Dividend Payments) + PV(Stock price when sold)
– Dividend Payment = 100 shares x 0.4925 per share = $49.25 per qtr
– PV(Dividend Payments) = 49.25 x Factor from 17A.2 where n=20, i=1%
• = 49.25 x (P/A, .04/4, 5 x 4) = 49.25 x 18.0456 = 888.75
– PV(Stock price when sold) = 100 shares x 35.1 x Factor from 17A.1 where
n=20, i=1%
• = 3510 x (P/F, .04/4, 5 x 4) = 3510 x .8195 = 2876.45
– Present Value of the Stock= 888.75 + 2876.45 = 3765.2 (or $37.65 per share)
• Should you buy 100 of BCE?
– BCE is currently selling at $35.7. We calculate that the PV of the stock (its
intrinsic value) is $37.62.
– Though the stock is selling slightly less than its “intrinsic value”, we:
• Did not factor in brokerage fees on the buy or the sell (they are a small amount if
buying 100 shares, but would lower its intrinsic value)
• We made some assumptions to calculate the selling price of the stock
• Are not sure if we will sell in 5 years – might be before, might be after
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Valuing a Stock
• Since we have made some estimates and assumptions, we should use a
margin of safety to protect our investment.
• That is, if we value BCE at $37.1, maybe we need to buy at 10% or 20%
below this because we can’t be sure of exactly how long we will hold the
stock for or what it will be worth when we sell.
• Warren Buffet and Ben Graham (world’s most successful value investors)
suggest we use a margin of safety of 50%.
• Do we buy?
– Yes, if we don’t use a margin of safety
– No, if we take a margin of safety (currently BCE is only trading 4% below its intrinsic
value)
– The longer we hold the stock, the more dividends we’ll get and so the more safety the
dividend provides
– Typically, value stocks have EPS which rise over the years. Also, their dividends rise,
and so there is some inherent safety because we did not factor these in
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Issuing a Bond at a Discount
• A Discount on Bonds Payable (a contra-liability on the
balance sheet) occurs when a company issues a bond
which has a coupon rate below the market rate
– Investors will not want this bond as much because they could get a
higher rate in the market, so the value of the bond drops.
• When the company sells the bonds, the transaction looks
like this:
Date
Account Titles and explanation
PR
Jan 1
Cash
88447
Discount on Bonds Payable
11553
Bonds Payable
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Debit
Credit
100000
Issuing a Bond at a Discount
• The bond is a long term liability and would be shown as
below on the balance sheet
Balance Sheet
Current Assets
Cash
Accounts Receivable
Current Liabilities
101000
AP
750
2000
1500
Wages
Long-term Liabilities
Bonds Payable
100000
Less: Discount
11553
Owner’s Equity
Inventory
10000
Total Assets
113000 Total Liabilities + OE
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
88447
22303
113000
Issuing a Bond at a Premium
• A Premium on Bonds Payable (an accretion-liability on the
balance sheet) occurs when a company issues a bond
which has a coupon rate higher the market rate
– Investors will want to buy this bond up because investing in this
bond would yield more than the market could yield.
• When the company sells the bonds, the transaction looks
like this:
Date
Account Titles and explanation
Jan 1
Cash
PR
Debit
Credit
113687
Premium on Bonds Payable
13687
Bonds Payable
100000
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Issuing a Bond at a Premium
• Again, the bond is a long term liability and would be
shown as below on the balance sheet
Balance Sheet
Current Assets
Cash
Current Liabilities
126240
AP
750
Accounts Receivable
2000
1500
Inventory
10000
Wages
Long-term Liabilities
Bonds Payable
100000
Add: Premium
13687
Owner’s Equity
Total Assets
138240 Total Liabilities + OE
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
113687
22303
138240
Income Statement
• Regardless of whether the bond is sold at a premium or
discount, the company needs to pay interest on its
borrowings.
– The Bond Interest Expense account is shown against the Revenue
for the period
– The Bond Interest Expense account reduces the revenue
Income Statement
Sales Revenue
Expenses
Bond Interest Expense
Net Income
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
200000
2500
197500
Amortizing a Discount or Premium
• In the discount situation, the company will sell a $100,000 but
only get $88447 for it.
• Similarly, in a premium situation, the company will sell a
$100,000 but get more than that in cash
– It will still need to pay back the full face value of $100000 in 20 years.
– It acknowledges this by amortizing the discount and premium. The
payments themselves are still the $2500, but an additional (or reduced)
expense is recorded on the income statement to acknowledge the discount
• There are 2 ways to calculate the amortization:
– Straight-line Method
– Effective Interest Method
• For our purposes, we will not get into these details
– Just know how to calculate the interest payments and value the bond
based on the market rate
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Bond Retirements
• Bonds can be retired a number of ways
– They are paid out by cash at maturity
– A company can retire them early by buying them in the open
market
– Some bonds have a call option on them: allowing them to be
purchased at a stated price
– Some bonds also have a convertible option, allowing them to be
converted to shares, at the request of the bond holder.
• The details around these calculations will not be covered.
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Other Forms of Debt
• Long-term Notes Payable: These are similar to a bond, but
are an agreement between the company and just one lender
– Usually these require one repayment with interest
• Installment Notes: These are an obligation to one lender
requiring a series of payments. Interest and some portion of
principal is repaid in each payment
• Mortgage Notes: Similar to a long-term notes payable,
except that the note is made with a contract pledging defined
assets in the event of default by the borrower on the note.
• Again, we will not cover the details of these.
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Try the Mid-Chapter Demo Problem
• Check out the mid-chapter demo problem, do parts 1 and 2
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Exercises
• Do
– Exercise 17-1
– Exercise 17-2
– Exercise 17-7
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD