Long-term
Liabilities
© Copyrright Doug Hillman 2000
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Bonds
Written promise to pay a specific sum of
money on a speciific future date
 Purchaser is bondholder
 Receives Bond certificate
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© Copyrright Doug Hillman 2000
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Classification of Bonds
Registered - issued in name of holder
 Secured - assets pledged as security
 Debenture (unsecured) - based on
general credit
 Serial - mature in installments
 Callable - corporation has option of
retiring
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© Copyrright Doug Hillman 2000
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Bonds Compared to Stock
Bondholders are
creditors
Bonds a liability
Interest is fixed charge
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Interest is expense
Interest tax deductible
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No voting
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© Copyrright Doug Hillman 2000
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Stockholders are
owners
Stock is equity
Dividends not fixed
charges
Dividends not expense
Dividends not tax
deductible
Voting
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Financial Leverage
Borrowed money invested within
business to earn a higher rate than
borrowing cost
 When positive financial leverage occurs,
use of bonds will produce higher EPS
than financing same investment with
stock
 Use of bonds will also produce higher
amount available for reinvestment

© Copyrright Doug Hillman 2000
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Bond Terms
Face value
› The principal of the bond payable at
maturity
 Stated interest rate
› The rate multiplied by face value to
get periodic cash interest payment
 Term
› Time to maturity

© Copyrright Doug Hillman 2000
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Why Bonds Sell at
Discount or Premium

When market interest rate on
comparable grade bonds is higher or
lower than the stated rate,
© Copyrright Doug Hillman 2000
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Why Bonds Sell at
Discount or Premium

When market interest rate on
comparable grade bonds is higher or
lower than the stated rate, investors will
adjust the purchase price of the bond so
that they earn the desired market
interest rate
© Copyrright Doug Hillman 2000
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Why Bonds Sell at
Discount or Premium
Why Bonds Sell at Discount or
PremiumWhen market interest rate on
comparable grade bonds is higher or
lower than the stated rate, investors will
adjust the purchase price of the bond so
that they earn the desired market
interest rate
 Issuing price determines effective or
yield rate

© Copyrright Doug Hillman 2000
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Why Bonds Sell at
Discount or Premium
If the market rate is higher than stated
rate, investors will offer less than face
value
 Difference between price paid and face
value is discount
 Effective interest rate is higher than
stated interest rate

© Copyrright Doug Hillman 2000
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Why Bonds Sell at
Discount or Premium
If market rate is lower than stated rate,
investors will offer more than face value
 Difference between price paid and face
value is premium
 Effective interest rate is lower than
stated interest rate

© Copyrright Doug Hillman 2000
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Sales Price of Bond
Bond promises two future cash flows
› Periodic interest payments
› Principal at maturity
 Price of bond today is the sum of the
present value of these two future cash
flows discounted at the interest rate the
investor desires to earn (market rate)

© Copyrright Doug Hillman 2000
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Calculation of Bond Price
Assume $100,000, 10%, 10 year bond,
interest payable semiannually on 6/30
and 12/31, market interest rate 12%
 Since the market interest rate (12%) is
higher than the stated interest rate
(10%), the bond should sell at a
discount

© Copyrright Doug Hillman 2000
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Calculation of Bond Price
PV of face amount (i=6%,n=20)
› $100,000 x 0.312 =
$31,200
 PV of interest payments
› $5,000 x 11.470 =
$57,350
 Price of bond =
$88,550

© Copyrright Doug Hillman 2000
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Issuance of Bonds
Increase Cash for the proceeds of
issuance
 Increase Bonds Payable for face value
 Increase Premium or Discount for the
difference

© Copyrright Doug Hillman 2000
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Amortization of
Premium or Discount
The premium or discount is an
adjustment to the interest
 To record the proper interest expense,
we must amortize the premium or
discount
 Two methods
› Straight-line - constant amortization
› Effective interest - constant effective
rate
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© Copyrright Doug Hillman 2000
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Recording Interest
Straight-Line
Decrease Cash for
› Face amount x Stated rate X Time
 Decrease Premium or Discount for
› Premium or Discount / Time to
maturity
 Increase Interest Expense for
› Sum of cash and amortization

© Copyrright Doug Hillman 2000
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Recording Interest
Effective Interest Method
Decrease Cash for
› Face amount x Stated Rate x Time
 Increase Interest Expense for
› Carrying value x Effective Interest
Rate x Time
 Decrease Premium or Discount for
› The difference between cash and
interest expense
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© Copyrright Doug Hillman 2000
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Discount Amortization
Example
$10,000, 10%, 2 year bond
 Interest payable semiannually
 Market interest rate 11%
 Issue price $9,822.50
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© Copyrright Doug Hillman 2000
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Discount Amortization
Straight-Line
Pd
0
1
2
3
4
Cash
500.00
500.00
500.00
500.00
© Copyrright Doug Hillman 2000
Exp Amort
544.38
544.38
544.38
544.38
44.38
44.38
44.38
44.36
CV
9,822.50
9,866.88
9,911.26
9,955.64
10,000.00
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Proof of Interest
Future cash payments
Face
Interest
Total
Cash received
Total interest
Semiannual interest
$2,177.50 / 4 = $544.38
© Copyrright Doug Hillman 2000
$10,000.00
2,000.00
$12,000.00
9,822.50
$2,177.50
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Discount Amortization
Effective Interest
Pd
0
1
2
3
4
Cash
500.00
500.00
500.00
500.00
Exp Amort
540.24
542.45
544.79
547.25
40.24
42.45
44.79
47.25
CV
9,822.50
9,862.74
9,905.19
9,949.98
*9,997.23
*rounding error
© Copyrright Doug Hillman 2000
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Premium Amortization
Example
$10,000, 10%, 2 year bond
 Interest payable semiannually
 Market interest rate 9%
 Issue price $10,184.00

© Copyrright Doug Hillman 2000
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Premium Amortization
Straight-Line
Pd
0
1
2
3
4
Cash
500.00
500.00
500.00
500.00
© Copyrright Doug Hillman 2000
Exp Amort
454.00
454.00
454.00
454.00
46.00
46.00
46.00
46.00
CV
10,184.00
10,138.00
10,092.00
10,046.00
10,000.00
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Proof of Interest
Future cash payments
Face
Interest
Total
Cash received
Total interest
Semiannual interest
$1,816.00 / 4 = $454.00
© Copyrright Doug Hillman 2000
$10,000.00
2,000.00
$12,000.00
10,184.00
$1,816.00
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Premium Amortization
Effective Interest
Pd
0
1
2
3
4
Cash
500.00
500.00
500.00
500.00
Exp Amort
458.28
456.40
454.44
452.39
41.72
43.60
45.56
47.61
CV
10,184.00
10,142.28
10,098.68
10,053.12
*10,005.51
*rounding error
© Copyrright Doug Hillman 2000
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Issuance Between
Interest Dates
Interest since last interest payment date
accrues to date of issuance at the stated
rate
 Proceeds of issuance include
› Market price of bond
› Accrued interest
–Accrued interest increases Interest
Payable

© Copyrright Doug Hillman 2000
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Issuance Between
Interest Dates
Next interest payment is for full 6
months and pays off Interest Payabe
 Resulting interest expense is only for
period since issuance
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© Copyrright Doug Hillman 2000
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Mortgage Notes Payable
Long-term note with assignment of an
interest in property
 Mortgage paid in equal periodic
installments
 Each payment includes
› Interest at specified rate on unpaid
principal
› Reduction of principal for difference
between payment and interest
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© Copyrright Doug Hillman 2000
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Analyzing Information
Is the level of total debt manageable?
 Does it seem likely interest and principal
payments can be met?
› Times Interest Earned ratio
› Debit ratio
 If firm needs additional financing, would
you recommend lending or investing in
it?
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© Copyrright Doug Hillman 2000
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