Chapter 10: Summary Cheat Sheet

Bond Basics Bonds are long-term debt securities issued by companies or governments to raise capital. They have several advantages and disadvantages: Advantages of Bonds: 1. No Effect on Ownership Control: Issuing bonds allows a company to raise capital without diluting ownership. 2. Tax Deductibility: Interest payments on bonds are tax-deductible, reducing the company's taxable income. 3. Potential to Increase Return on Equity: If the return on the capital raised exceeds the cost of bond interest, it can enhance equity returns. Disadvantages of Bonds: 1. Potential to Decrease Return on Equity: If the cost of debt exceeds returns, it can reduce equity returns. 2. Mandatory Payments: Bonds require fixed periodic interest payments and repayment of the par value at maturity. Bonds Issued at Par Value • • • Par Bonds: Bonds issued at par value have an issue price equal to their face value, and the interest payments are based on the stated contract rate. Semiannual Interest Payment: For par bonds, the interest payment is calculated using the bond's par value and the contract rate, typically paid twice a year. Maturity Payment: At maturity, the issuer repays the bondholder the par value. Discount Bonds • • • • Contract Rate vs. Market Rate: When the contract rate (coupon rate) is lower than the market rate, the bonds are issued at a discount, meaning the issue price is less than the par value. Bond Prices: For example, a $1,000 bond priced at 96.400 is issued for $964, while a $1,000 bond priced at 103½ is issued for $1,035. Carrying Value: The carrying value equals the bond's par value plus any premium or minus any discount. Amortizing Discount Bonds: The discount is gradually reduced over time, increasing the carrying value of the bond until it reaches par at maturity. This can be done using the straight-line method. Premium Bonds • • Definition: Premium bonds are issued when the contract rate is higher than the market rate, resulting in an issue price above par value. Amortization: The premium is amortized over the life of the bond, gradually decreasing the carrying value to par by maturity. Bond Retirement • • Call Option: Some bonds have a call feature that allows issuers to redeem the bonds before maturity by paying the par value plus a call premium. Gain or Loss on Retirement: If the carrying value is higher than the retirement price, the issuer records a gain. If lower, a loss is recorded. Long-Term Notes • • Installment Note: A liability that requires regular payments to a lender, typically including both interest and principal portions. Amortization Table: Shows the schedule of payments, including interest and principal reduction, for each period. Multiple Choice Quiz Summary 1. Bond Trading at 97½: This means the bond is trading at $975 per $1,000 face value. 2. Investor Rights for Term Bond: An investor in a $1,000, 6%, 15-year bond has the right to receive $1,000 at maturity and $60 annually. 3. Interest on 8%, 20-Year Bond: For semiannual payments, $20,000 is owed per payment. 4. Interest Expense for Discount Bond: Using straight-line amortization, total interest expense includes cash interest and amortization of the discount. 5. Amortization of Premium: For premium bonds, the premium is amortized over the bond's life, reducing the bond's carrying value. Understanding these concepts is key for analyzing bond investments, corporate financing decisions, and accounting practices for long-term debt.