OPEN UNIVERSITY HCMC MBA PREPARATORY COURSE Principles of Financial Accounting Lecturer: NGUYEN TAN BINH 06/04/16 NGUYEN TAN BINH - PH Chapter Valuing and Accounting for Bonds and Leases 06/04/16 NGUYEN TAN BINH - PH Learning Objectives After studying this chapter, you should be able to: • Compute and interpret present and future values • Value bonds using present value techniques • Account for bond issues over their entire life • Value and account for long-term lease transactions • Evaluate pensions and other postretirement benefits 06/04/16 NGUYEN TAN BINH - PH Valuing Long-Term Liabilities • Long-term liabilities are more difficult to value than short-term liabilities because of the long time frames involved • Accountants use the time value of money to value long-term liabilities – The time value of money refers to the fact that a dollar you expect to pay or receive in the future is not worth as much as a dollar you have today 06/04/16 NGUYEN TAN BINH - PH Compound Interest, Future Value, and Present Value • When money is borrowed, the amount borrowed is known as the loan principal – For the borrower, interest is the cost of using the principal • Investing money is the same as making a loan – The interest received is the return on the investment 06/04/16 NGUYEN TAN BINH - PH Compound Interest, Future Value, and Present Value • Calculating the amount of interest depends on the interest rate and the interest period • Types of interest: – Simple interest - the interest rate multiplied by an unchanging principal amount – Compound interest - the interest rate multiplied by a changing principal amount • The unpaid interest is added to the principal balance and becomes part of the new principal balance for the next interest period 06/04/16 NGUYEN TAN BINH - PH Future Value • Future value - the amount accumulated over time, including principal and interest – For example, if a person lets $10,000 sit in a bank account that pays 10% interest per year for years, the future value of the $10,000 is $13,310 and is determined as follows: Year 1: Year 2: Year 3: 06/04/16 $10,000 x 1.10 = $11,000 $11,000 x 1.10 = $12,100 $12,100 x 1.10 = $13,310 NGUYEN TAN BINH - PH Future Value • The general formula for computing the future value (FV) of S dollars in n years at interest rate i is: FV = S (1 + i ) n n refers to the number of periods the funds are invested The interest rate must be stated consistently with the time period 06/04/16 NGUYEN TAN BINH - PH Future Value • The calculations for future values can be very tedious Most people use future value tables to determine future values – In the table, each number is the solution to the expression (1 + i)n – The value of i is given in the column heading – The value of n is given in the row label for the number of periods 06/04/16 NGUYEN TAN BINH - PH Future Value To how much will $25,000 grow if left in the bank for 20 years at 6% interest? The answer is determined as follows: $25,000 x 3.2071* = $80,177.50 *3.2071 is the future value factor for 20 periods at 6% interest 06/04/16 NGUYEN TAN BINH - PH 10 Present Value • The general formula for the present value (PV) of a future value (FV) to be received or paid in n periods at an interest rate of i per period is: FV PV = n (1 + i ) 06/04/16 NGUYEN TAN BINH - PH 13 Present Value • Just as with future values, tables can be helpful in determining the present value of amounts – In the table, each number is the solution to the expression 1/(1 + i)n – The value of i is given in the column heading – The value of n is given in the row label for the number of periods 06/04/16 NGUYEN TAN BINH - PH 14 Present Value • Interest rates are sometimes called discount rates in calculations involving present values • Present values are also called discounted values, and the process of finding the present value is discounting – Present values can be thought of as decreasing the value of a future cash inflow or outflow because the cash is to be received or paid in the future, not today 06/04/16 NGUYEN TAN BINH - PH 15 Present Value A city wants to issue $100,000 of noninterest-bearing bonds to be repaid in a lump sum in years How much should investors be willing to pay for the bonds if they require a 10% return on their investment? $100,000 x 6209* = $62,090 *.6209 is the present value of $1 factor for years at 10% interest 06/04/16 NGUYEN TAN BINH - PH 16 Present Value • Remember to pay attention to the number of periods Interest is often compounded semiannually instead of annually – If interest is compounded semiannually, the number of periods is twice the number of years, and the interest rate is one-half of the annual interest rate – In the previous example, if interest were compounded semiannually, the number of periods is 10 instead of 5, and the interest rate is 5% instead of 10% 06/04/16 NGUYEN TAN BINH - PH 17 Present Value of an Ordinary Annuity • Annuity - a series of equal cash flows to take place during successive periods of equal length • The present value of an annuity is the sum of the present values of each cash receipt or payment – If a note has a series of payments, its present value can be determined by finding the present value of each payment and adding those present values together 06/04/16 NGUYEN TAN BINH - PH 18 Present Value of an Ordinary Annuity • Again, tables can be helpful in determining the present value of an ordinary annuity • The factors in a present value of an annuity table are merely the cumulative sum of the present value of $1 factors in the present value of $1 table for the number of annuity periods – The present value of an ordinary annuity tables are especially helpful if the cash payments or receipts extend into the future over many periods 06/04/16 NGUYEN TAN BINH - PH 19 Present Value of an Ordinary Annuity A city wants to issue $1,000,000 of noninterest-bearing bonds to be repaid $100,000 per year for 10 years How much should investors be willing to pay for the bonds if they require a 10% return on their investment? $100,000 x 6.1446* = $614,460 *6.1446 is the present value of an annuity of $1 for 10 periods at 10% interest 06/04/16 NGUYEN TAN BINH - PH 20 Present Value of an Ordinary Annuity • Notice that the higher the interest rate, the lower the present value factor This occurs because at higher interest rates, less must be invested to obtain the same stream of future annuity payments or a certain amount in the future 06/04/16 NGUYEN TAN BINH - PH 21 Valuing Bonds • Because bonds create cash flows in future periods, they are recorded at the present value of those future payments, discounted at the market interest rate in effect when the liability is created • Bond - formal certificate of indebtedness that is typically accompanied by: – A promise to pay interest in cash at a specified annual rate plus – A promise to pay the principal at a specific maturity date 06/04/16 NGUYEN TAN BINH - PH 22 Valuing Bonds • When valuing bonds, the present value tables are used to determine the amount of proceeds that will be received – The present value of $1 table is used to determine the present value of the face amount of the bonds – The present value of an annuity of $1 is used to determine the present value of the series of interest payments – The amounts are added together to determine the amount of proceeds and any premium or discount 06/04/16 NGUYEN TAN BINH - PH 23 Valuing Bonds A company issues $20,000,000 of 5-year bonds with a coupon rate of 7% Interest is to be paid semiannually on June 30 and December 31 of each year At the time of the issuance, the market rate is 10% What is the amount of the proceeds and any premium or discount on the bonds? 06/04/16 NGUYEN TAN BINH - PH 24 Valuing Bonds • To determine the proceeds: $20,000,000 x 6139* = $12,278,000 $700,000‡ x 7.7217* = 5,405,190 $17,683,190 ($700,000 = ($20,000,000 x 7%) / 2) *PV factors are for 10 periods at 5% ‡ The company will receive $17,683,190 upon issuance The bonds are issued at a discount of $2,316,810 06/04/16 NGUYEN TAN BINH - PH 25 Interest Rates • Interest rates have three components – Real interest rate - the return that investors demand because they are delaying their consumption – Inflation premium - the extra interest that investors require because they worry that the general price level will change between now and the time they will receive their money – Firm specific risk - the risk that a firm will not repay the loan or will not pay the interest on time 06/04/16 NGUYEN TAN BINH - PH 26 Bonds Issued at a Discount • When bonds are issued at at discount, the amount of proceeds received from the issuance is less than the actual liability • The difference must be recorded in a separate account on the books Cash Discount on bonds payable Bonds payable 17,683,190 2,316,810 20,000,000 References: Horngren, Introduction to financial accounting 06/04/16 NGUYEN TAN BINH - PH 27 [...]... NGUYEN TAN BINH - PH 24 Valuing Bonds • To determine the proceeds: $20,000,000 x 6139* = $12,2 78, 000 $700,000‡ x 7.7217* = 5,405,190 $17, 683 ,190 ($700,000 = ($20,000,000 x 7%) / 2) *PV factors are for 10 periods at 5% ‡ The company will receive $17, 683 ,190 upon issuance The bonds are issued at a discount of $2,316 ,81 0 06/04/16 NGUYEN TAN BINH - PH 25 Interest Rates • Interest rates have three components... amount of proceeds received from the issuance is less than the actual liability • The difference must be recorded in a separate account on the books Cash Discount on bonds payable Bonds payable 17, 683 ,190 2,316 ,81 0 20,000,000 References: Horngren, Introduction to financial accounting 06/04/16 NGUYEN TAN BINH - PH 27 ... or payment – If a note has a series of payments, its present value can be determined by finding the present value of each payment and adding those present values together 06/04/16 NGUYEN TAN BINH - PH 18 Present Value of an Ordinary Annuity • Again, tables can be helpful in determining the present value of an ordinary annuity • The factors in a present value of an annuity table are merely the cumulative