Transcript Long-Term Liabilities: Bonds and Notes 12-1 11-1 Bond A bond is simply a form of an interest-bearing note.

12
Long-Term Liabilities:
Bonds and Notes
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Bond
A bond is simply a form of an
interest-bearing note. Like a
note, a bond requires periodic
interest payments, and the
face amount must be repaid at
the maturity date.
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Huckadee Corporation is considering the
following plans to issue debt and equity:
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Earnings per share (EPS) measure the income
earned by each share of common stock. It is
computed as follows:
Net Income – Preferred Dividends
Earnings per share =
Number of Common Shares
Outstanding
Data for Huckadee Corporation:
1. Earnings before interest and taxes are $800,000.
2. The tax rate is 40%.
3. All bonds or stocks are issued at their par or face value.
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Exhibit 1
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Effect of Alternative Financing
Plans—$800,000 earnings.
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Exhibit 2
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Effect of Alternative Financing
Plans—$440,000 earnings.
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Example Exercise 12-1
Alternative Financing Plans
Gonzales Co., is considering the following alternative plans
for financing their company:
Plan 1
Plan 2
Issue 10% Bonds (at face)
Issue $10 Common Stock
$3,000,000
$2,000,000
$1,000,000
Income tax is estimated at 40% of income.
Determine the earnings per share of common stock under
the two alternative financing plans, assuming income
before bond interest and income tax is $750,000.
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Example Exercise 12-1 (continued)
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Follow My Example 12-1
Plan 1
Plan 2
Earnings before bond interest
and income tax
Bond interest
Balance
($750,000 ×
Income tax
40%)
Net income
Dividend on preferred stock
Earnings available for
common stock
Number of common shares
Earnings per share on
common stock
For Practice: PE 12-1A, PE 12-1B
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Bond Characteristics
and Terminology
The underlying contract between
the company issuing bonds and
the bondholders is called a bond
indenture or trust indenture.
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Bond Characteristics
and Terminology
Usually, the face value of each
bond, called the principal, is
$1,000 or a multiple of $1,000.
Interest on bonds may be
payable annually, semiannually,
or quarterly. Most pay interest
semiannually.
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•
Bond Characteristics
and Terminology
When all bonds of an issue mature at the same
time, they are called term bonds.
• If the maturity dates are spread over several
dates, they are called serial bonds.
• Bonds that may be exchanged for other
securities are called convertible bonds.
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Bond Characteristics
and Terminology
• Bonds that a corporation reserves the
right to redeem before their maturity
are called callable bonds.
• Bonds issued on the basis of general
credit of the corporation are
debenture bonds.
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Proceeds from Issuing Bonds
The market or effective rate of interest
is determined by transactions between
buyers and sellers of similar bonds. The
market rate of interest is affected by a
variety of factors, including investors’
expectations of current and future
economic conditions.
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MARKET RATE = CONTRACT RATE
Selling price of bond = $1,000
If the contract rate equals the market rate of
interest, the bonds will sell at their face amount.
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MARKET RATE > CONTRACT RATE
Selling price of bond < $1,000
–
Discount
If the market rate is higher than the contract rate,
the bonds will sell at a discount.
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MARKET < CONTRACT RATE
Selling price of bond > $1,000
+
Premium
If the market rate is lower than the contract rate,
the bonds will sell at a premium.
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Bonds Issued at Face Amount
On January 1, 2009, Eastern Montana
Communications Inc. issued for cash
$100,000 of 12%, five-year bonds;
interest payable semiannually. The
market rate of interest is 12%.
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Since the bond rate of interest and the market rate
of interest are the same, the bonds will sell at their
face amount.
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Every six months (on June 30 and December 31)
after the bonds are issued, interest of $6,000
($100,000 × .12 × 6/12) is paid.
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The bond matured on December 31, 2013. At this
time, the corporation paid the face amount to the
bondholder.
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Installment Notes
An installment note is a debt that requires the
borrower to make equal periodic payments to
the lender for the term of the note. Unlike
bonds, a note payment consists of payment of
a portion of the amount initially borrowed (the
principal) and payment of interest on the
outstanding balance.
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