Lecture 9 - Bonds (cont.)

Amortizing the Discount

Over some period of time, you need to get the discount down to zero. You go thru the process at each payment date. Credit to Cash the amount that you have to pay out (interest rate x face value). Credit the Discount also to reduce it.

Interest Expense as a percentage of the carry value of the bond will be greater than the interest rate on the bond since it has to be the sum of the amount creditted to Cash (the interest amount) plus the amount of the discount being amortized.

Example:
Bond face value is 1,000,000
interest rate 5% per year
term = 20 years
interest is paid semi annually

Calculations:
cash payment is 5% of 1,000,000 = 50,000 per year. for half a year, it's 25,000. therefore, credit Cash 25,000. discount is 100,000. amortize over 40 payment periods - 2,500 per period. therefore, credit Discount 2,500. and the Debit Interest Expense 25,000+2,500 = 27,500.

Journal Entries:
Dr. Interest Expense 27,500
--- Cr. Discount 2,500
--- Cr. Cash 25,000

Bonds Bought/Sold between Interest Payment Dates

You're not entitled to the entire next interest payment. Issuing company just pays the full amount to the bond holder at the end of the period. The buyer pays the cost of the bond plus the accrued interest until the time of the sale. (Not covering calculations in detail.)

Retirement of Bonds

The issuing company may call back bonds. This usually happens when the market rate for the bond is going down because interest rates are going down. These are called "Callable Bonds". Even if a bond is not callable, the company may buy them back on the open market.

Getting the bond back

Retirement of Bonds

If interest rates go down and you decide to purchase on the open market one set of bonds and issue a new set at a lower rate, are you likely to recognize a loss on early retirement of the bond.

Even though this incurs a loss, in the long run it may well be in the best interest of the company to redeem the bonds and reissue at a lower rate.

Conversion of Bonds

This refers to converting bonds into stock.

Ex: bond issue is $1,000,000. 1000 bonds worth $1000 each. Each bond is convertible into 40 shares of common stock. Common Stock is selling at $15/share. Converting at this point is not a good idea since it would only bring in $600.

But in the long run, the ability to convert is valuable in case common stock goes up. This is known as an “equity kicker”. As a buyer, you may be willing to pay more for a convertible bond, i.e. be willing to accept a lower interest rate.

If later the stock price is $30. Then, it would be in your interest to convert. This could be good for the company as well.

Journal entries to move bond entries to equity accounts
Dr. Bonds Payable
Dr. Premium (either/or)
Cr. Discount (either/or)
Cr. Common Stock
Cr. Additional PIC (paid-in capital)