CHAPTER 14 LONG-TERM LIABILITIES: BONDS AND NOTES DISCUSSION QUESTIONS (1) To pay the face (maturity) amount of the bonds at a specified date (2) To pay periodic interest at a specified percentage of the face amount a Bonds that may be exchanged for other securities under specified conditions b The issuing corporation reserves the right to redeem the bonds before the maturity date c Bonds issued on the basis of the general credit of the corporation More than face amount Because comparable bonds provide a market interest rate (11%) that is less than the rate on the bond being issued (12%), the bond will sell at a premium as the market’s means of equalizing the two interest rates a Greater than $26,000,000 b $26,000,000 7% 9% $26,000,000 Less than the contract rate a Premium b $593,454 c Premium on Bonds Payable A loss of $50,000 [($5,000,000 × 0.98) – ($5,000,000 – $150,000)] A mortgage note is an installment note that is secured by a pledge of the borrower’s assets If the borrower fails to pay the note, the lender has the right to take possession of the pledged asset and sell it to pay off the debt A bond is an interest-bearing note that requires periodic interest payments and repayment of the face amount of the bonds at maturity Bonds consist of two different components: (1) interest payments made periodically over the life of the bond and (2) the face amount that must be repaid at maturity The periodic payments consist entirely of interest, and the final payment at maturity consists entirely of principal Installment notes, on the other hand, have periodic payments that consist partially of interest and partially of principal Each payment reduces the principal on the note so that at maturity the entire amount borrowed will have been repaid 10 a As a current liability on the balance sheet b As a long-term liability on the balance sheet 14-1 © 2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER 14 Long-Term Liabilities: Bonds and Notes PRACTICE EXERCISES PE 14–1A Earnings before bond interest and income tax…………… Deduct interest on bonds……………………………………… Income before income tax…………………………………… Deduct income tax……………………………………………… Net income……………………………………………………… Dividends on preferred stock………………………………… Available for dividends on common stock………………… Shares of common stock outstanding……………………… Earnings per share on common stock……………………… Plan Plan $1,200,000 360,000 $1,200,000 300,000 $ 840,000 336,000 $ 900,000 360,000 $ 504,000 $ 540,000 300,000 $ 504,000 ÷ 300,000 $ 1.68 $ 240,000 ÷ 200,000 $ 1.20 Plan Plan $6,000,000 × 6% $840,000 × 40% $5,000,000 × 6% $900,000 × 40% ($3,000,000 ÷ $30) × $3.00 PE 14–1B Earnings before bond interest and income tax…………… $2,000,000 $2,000,000 400,000 250,000 Deduct interest on bonds……………………………………… Income before income tax……………………………………… $1,600,000 $1,750,000 640,000 700,000 Deduct income tax……………………………………………… Net income………………………………………………………… Dividends on preferred stock………………………………… Available for dividends on common stock………………… Shares of common stock outstanding………………… Earnings per share on common stock……………………… $4,000,000 × 10% $1,600,000 × 40% $2,500,000 × 10% $1,750,000 × 40% ($3,000,000 ữ $25) ì $2.50 14-2 â 2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part PE 14–2A Cash Discount on Bonds Payable Bonds Payable PE 14–2B Cash Discount on Bonds Payable Bonds Payable PE 14–3A Interest Expense Discount on Bonds Payable* Cash * $79,127 ÷ 10 semiannual payments PE 14–3B Interest Expense Discount on Bonds Payable* Cash * $110,401 ÷ 10 semiannual payments PE 14–4A Cash Premium on Bonds Payable Bonds Payable PE 14–4B Cash Premium on Bonds Payable Bonds Payable 14-3 © 2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part PE 14–5A Interest Expense Premium on Bonds Payable* Cash * $175,041 ÷ 10 semiannual payments PE 14–5B Interest Expense Premium on Bonds Payable* Cash * $308,869 ÷ 10 semiannual payments PE 14–6A Bonds Payable Loss on Redemption of Bonds Discount on Bonds Payable Cash PE 14–6B Bonds Payable Premium on Bonds Payable Gain on Redemption of Bonds Cash PE 14–7A a b Cash Notes Payable Issued installment notes for cash Interest Expense Notes Payable Cash Paid principal and interest on installment notes PE 14–7B a b Cash Notes Payable Issued installment notes for cash Interest Expense Notes Payable Cash Paid principal and interest on installment notes PE 14–8A a Number of times interest charges earned: $3,200,000 + $320,000 = 11.0 2014: $320,000 2013: b $3,600,000 + $300,000 = 13.0 $300,000 The number of times interest charges are earned has decreased from 13.0 in 2013 to 11.0 in 2014 Although the company has adequate earnings to pay interest, the decline in this ratio may cause concern among debtholders PE 14–8B a Number of times interest charges earned: $5,544,000 + $440,000 = 13.6 2014: $440,000 2013: b $4,400,000 + $400,000 = 12.0 $400,000 The number of times interest charges are earned has increased from 12.0 in 2013 to 13.6 in 2014 The increase in this ratio increases debtholders’ confidence in the company’s ability to make its interest payments EXERCISES Ex 14–1 a Rhett Co Earnings before bond interest and income tax………………………………… Bond interest………………………………………………………………………… Balance……………………………………………………………………………… Income tax…………………………………………………………………………… Net income…………………………………………………………………………… Dividends on preferred stock…………………………………………………… Earnings available for common stock………………………………………… Shares of common stock outstanding…………………………………………… Earnings per share on common stock…………………………………………… b Earnings before bond interest and income tax……………………………… Bond interest………………………………………………………………………… Balance………………………………………………………………………………… Income tax…………………………………………………………………………… Net income…………………………………………………………………………… Dividends on preferred stock……………………………………………………… Earnings available for common stock…………………………………………… Shares of common stock outstanding………………………………………… Earnings per share on common stock………………………………………… c Earnings before bond interest and income tax……………………………… Bond interest………………………………………………………………………… Balance………………………………………………………………………………… Income tax…………………………………………………………………………… Net income…………………………………………………………………………… Dividends on preferred stock……………………………………………………… Earnings available for common stock…………………………………………… Shares of common stock outstanding………………………………………… Earnings per share on common stock………………………………………… Ex 14–2 Factors other than earnings per share that should be considered in evaluating financing plans include: bonds represent a fixed annual interest requirement, while dividends on stock not; bonds require the repayment of principal, while stock does not; and common stock represents a voting interest in the ownership of the corporation, while bonds not Ex 14–3 Nike’s major source of financing is common stock It has relatively little long-term debt compared to stockholders’ equity Ex 14–4 The bonds were selling at a premium This is indicated by the selling price of 115.948, which is stated as a percentage of the face amount and is more than par (100%) The market rate of interest for similar quality bonds was lower than 7.25%, and this is why the bonds were selling at a premium Ex 14–5 Apr Cash Bonds Paya Oct Interest Expen Cash Dec 31 Interest Expen Interest Pay * $7,500,000 × 10% × 3/12 Ex 14–6 a Cash Discount on Bonds Payable Bonds Payable Interest Expense Cash Interest Expense Cash Interest Expense Discount on Bonds Payable Ex 14–6 (Concluded) b Annual interest paid………………………………………………………………… Plus discount amortized………………………………………………………… Interest expense for first year…………………………………………………… c The bonds sell for less than their face amount because the market rate of interest is greater than the contract rate of interest Investors are not willing to pay the full face amount for bonds that pay a lower contract rate of interest than the rate they could earn on similar bonds (market rate) Ex 14–7 a Cash Premium on Bonds Payable Bonds Payable b Interest Expense Premium on Bonds Payable* Cash** * $2,842,560 ữ 20 semiannual payments ** $20,000,000 ì 9% ì 6/12 c The bonds sell for more than their face amount because the market rate of interest is less than the contract rate of interest Investors are willing to pay more for bonds that pay a higher rate of interest (contract rate) than the rate they could earn on similar bonds (market rate) Ex 14–8 2014 Apr Cash Bonds Paya Oct Interest Expen Cash 2018 Oct Bonds Payable Loss on Redem Cash* * $40,000,000 × 1.04 Ex 14–9 2014 Mar Cash Bonds Paya Sept Interest Expen Cash 2020 Sept Bonds Payable Gain on Re Cash* * $30,000,000 × 0.98 Ex 14–10 a Cash Notes Payable Interest Expense* Notes Payable Cash * $50,000 × 0.05 b Notes payable are reported as liabilities on the balance sheet The portion of the note payable that is due within one year is reported as a current liability The remaining portion of the note payable that is not due within one year is reported as a long-term liability For this company, the current and noncurrent portions of the note payable would be reported as follows: Ex 14–10 (Concluded) Current liabilities: Notes payable*……………………………………………………………………… $ 7,719 * The principal repayment portion of the next installment payment See computation below Noncurrent liabilities: Notes payable**…………………………………………………………………… ** Original note payable…………………………………………………………… $34,930 $50,000 Less principal repayment from year 1……………………………………… Note payable balance at the end of year 1………………………………… Annual payment on note……………………………………………………… Second year interest payment ($42,649 × 0.05)…………………………… Principal repayment portion of next installment………………………… Note payable balance at the end of year 1………………………………… Current portion of note payable (due within one year)………………… Noncurrent portion of note payable………………………………………… Ex 14–11 2014 Jan Cash Notes Paya Dec 31 Interest Expen Notes Payable Cash 2017 Dec 31 Interest Expen Notes Payable Cash *$46,813 – $10,665 Prob 14–3A Cash Premium on Bonds Payable Bonds Payable Interest Expense Premium on Bonds Payable* Cash a * Interest Expense Premium on Bonds Payable* Cash b * $41,403,720 ÷ 40 seminannual payments $41,403,720 ÷ 40 semiannual payments $7,964,907 Yes Investors will be willing to pay more than the face amount of the bonds when the interest payments they will receive from the bonds exceed the amount of interest that they could receive from investing in other bonds Present value of $1 for 40 semiannual 0.17193 periods at 4.5% semiannual rate……………………………… Face amount of bonds…………………………………………… × $150,000,000 $ 25,789,500 Present value of annuity of $1 for 40 semiannual periods at 4.5% semiannual rate……… Semiannual interest payment…………………………………… × $ Proceeds of bond issue………………………………………… 165,614,220 $191,403,720 18.40158 9,000,000 Prob 14–4A 2014 July Oct Dec 31 31 31 31 2015 June 30 Sept 30 Dec 31 31 31 31 2016 June * $88,000,000 × 0.97 30 Prob 14–4A (Concluded) 2016 Sept 30 Interest E Interest P Notes Pay Cash a b Initial carrying amount of bonds…………………………………………………… Discount amortized on December 31, 2014…………………………………… Discount amortized on December 31, 2015……………………………………… Carrying amount of bonds, December 31, 2015………………………………… Appendix and Prob 14–5A 2014 July a 2014 Dec 31 *$91,420,905 × 5.0% 2015 June b 30 *($91,420,905 + $71,045) × 5.0% $4,571,045 Appendix and Prob 14–6A 2014 July a 2014 Dec 31 *$191,403,720 × 4.5% b 2015 June *($191,403,720 – $386,833) × 4.5% $8,613,167 30 Prob 14–1B Earnings before interest and income tax……… Deduct interest on bonds………………………… Income before income tax………………………… Deduct income tax…………………………………… Net income…………………………………………… Dividends on preferred stock…………………… Available for dividends on common stock…… Shares of common stock outstanding…………… Earnings per share on common stock…………… Earnings before interest and income tax……… Deduct interest on bonds………………………… Income before income tax………………………… Deduct income tax………………………………… Net income…………………………………………… Dividends on preferred stock……………………… Available for dividends on common stock……… Shares of common stock outstanding………… Earnings per share on common stock………… The principal advantage of Plan is that it involves only the issuance of common stock, which does not require a periodic interest payment or return of principal, and a payment of preferred dividends is not required It is also more attractive to common shareholders than is Plan or if earnings before interest and income tax is $6,000,000 In this case, it has the largest EPS ($0.90) The principal disadvantage of Plan is that, if earnings before interest and income tax is $10,000,000, it offers the lowest EPS ($1.50) on common stock The principal advantage of Plan is that less investment would need to be made by common shareholders Also, it offers the largest EPS ($2.84) if earnings before interest and income tax is $10,000,000 Its principal disadvantage is that the bonds carry a fixed annual interest charge and require the payment of principal It also requires a dividend payment to preferred stockholders before a common dividend can be paid Finally, Plan provides the lowest EPS ($0.44) if earnings before interest and income tax is $6,000,000 Plan provides a middle ground in terms of the advantages and disadvantages described in the preceding paragraphs for Plans and Prob 14–2B Cash Discount on Bonds Payable Bonds Payable a Interest Expense Discount on Bonds Payable* Cash *$3,690,764 ÷ 40 semiannual payments b Interest Expense Discount on Bonds Payable* Cash *$3,690,764 ÷ 40 semiannual payments $2,392,269 Yes Investors will not be willing to pay the face amount of the bonds when the interest payments they will receive from the bonds are less than the amount of interest that they could receive from investing in other bonds Present value of $1 for 40 semiannual periods at 5.5% semiannual rate………………………………… 0.11746 Face amount of bonds…………………………………………… × $46,000,000 $ 5,403,160 Present value of an annuity of $1 for 40 semiannual periods at 5.5% semiannual rate……… 16.04612 Semiannual interest payment………………………………………× $ 2,300,000 Proceeds of bond issue…………………………………………… 36,906,076 $42,309,236 Prob 14–3B Cash Premium on Bonds Payable Bonds Payable a Interest Expense Premium on Bonds Payable* Cash *$8,100,469 ÷ 20 semiannual periods b Interest Expense Premium on Bonds Payable* Cash *$8,100,469 ÷ 20 semiannual periods $3,494,977 Yes Investors will be willing to pay more than the face amount of the bonds when the interest payments they will receive from the bonds exceed the amount of interest that they could receive from investing in other bonds Present value of $1 for 20 semiannual periods at 5% semiannual rate………………………………… 0.37689 Face amount of bonds…………………………………………… × $65,000,000 Present value of annuity of $1 for 20 semiannual periods at 5% semiannual rate………… 12.46221 Semiannual interest payment…………………………………… × $ 3,900,000 Proceeds of bond issue…………………………………………… $24,497,850 48,602,619 $73,100,469 Prob 14–4B 2014 July Oct Dec 31 31 31 31 2015 June 30 Sept 30 Dec 31 31 31 31 2016 June *$55,000,000 × 1.03 30 Prob 14–4B (Concluded) 2016 Sept 30 Interes Interes Notes Cas a b Initial carrying amount of bonds………………………………………………… $62,817,040 Premium amortized on December 31, 2014…………………………………… (390,852) (781,704) Premium amortized on December 31, 2015…………………………………… $61,644,484 Carrying amount of bonds, December 31, 2015……………………………… Appendix and Prob 14–5B 2014 July a 2014 Dec 31 *$42,309,236 × 5.5% 2015 June b 30 *($42,309,236 + $27,008) × 5.5% $2,327,008 Appendix and Prob 14–6B 2014 July a 2014 Dec 31 *$73,100,469 × 5% b 2015 June *($73,100,469 – $244,977) × 5% $3,655,023 30 CASES & PROJECTS CP 14–1 GE Capital’s action was legal, but caused a great public relations stir at the time Some quotes: “A lot of people feel like they have been sorely used,” said one bond fund manager “There was nothing illegal about it, but it was nasty.” The fund manager said that GE Capital’s decision to upsize its bond issue to $11 billion from $6 billion midway through the offering ordinarily wouldn’t have upset bondholders “But then to find out two days later that they had filed a $50 billion shelf?” he said “People buy GE because it’s like buying Treasuries, not because they want to get jerked around.” GE Capital’s action was probably ethical, even though it caused some stir In its own defense, it stated: In a statement released late Thursday, GE Capital said “with the $11 billion bond issuance of March 13, GE Capital exhausted its existing debt shelf registration; consequently, on March 20, GE Capital filed a $50 billion shelf registration.” The release said the shelf filing was not an offering and that it would be used in part to roll over $31 billion in maturing long-term debt In retrospect, GE Capital could have been a little more forthcoming about its financing plans prior to selling the $11 billion of bonds, but there was nothing unethical or illegal about its disclosures Source: “GE Capital Timing on $50B Shelf Filing Added to Backlash,” Dow Jones Capital Markets Report , March 22, 2002, Copyright (c) 2002, Dow Jones & Company, Inc CP 14–2 Without the consent of the bondholders, Bob’s use of the sinking fund cash to temporarily alleviate the shortage of funds would violate the bond indenture contract and the trust of the bondholders It would therefore be unprofessional In addition, the use of Bob’s brother-in-law as trustee of the sinking fund is a potential conflict of interest that could be considered unprofessional CP 14–3 Receive $100,000,000 today: Present value of $100,000,000 today = $100,000,000 Receive $25,000,000 today, plus $9,000,000 per year for years: Present value of $25,000,000 today = $25,000,000 Present value of annual payments = $9,000,000 × 5.97130 (Present value of an annuity of $1 for periods at 7%) = $53,741,700 Total value = Present value of $25,000,000 + Present value of annual payments Total value = $25,000,000 + $53,741,700 = $78,741,700 Receive $15,000,000 per year for 10 years: Present value of annual payments = $15,000,000 × 7.02358 (Present value of an annuity of $1 for 10 periods at 7%) = $105,353,700 The option that has the highest value in terms of present value is to receive $15,000,000 a year for 10 years CP 14–4 The primary advantage of issuing preferred stock rather than bonds is that the preferred stock does not obligate Xentec to pay dividends, while interest on bonds must be paid The issuance of bonds will require annual interest payments, necessitating a periodic (probably semiannual) cash outflow Given Sweeping Sweeping Bluff Golf Course’s volatility of operating cash flows, the required interest payments might strain Xentec’s liquidity In the extreme, this could even lead to a bankruptcy of Xentec The issuance of bonds has the advantage of providing a tax deduction for interest expense This would tend to reduce the net (after-tax) cost of the bonds Probably the safest alternative is for Xentec to issue preferred stock Of course, another alternative might be to issue a combination of preferred stock and bonds CP 14–5 Plan 1 Shares of common stock………………………………… Plan 400,000 950,000 Earnings before bond interest and income tax……… Deduct interest on bonds………………………………… Income before income tax………………………………… Deduct income tax………………………………………… Net income…………………………………………………… $5,000,000 2,080,000 $5,000,000 1,200,000 $2,920,000 1,168,000 $3,800,000 1,520,000 $1,752,000 Earnings per share on common stock………………… $ $2,280,000 $ 2.40** 4.38* * $1,752,000 ÷ 400,000 ** $2,280,000 ÷ 950,000 a b Factors to be considered in addition to earnings per share: There is a definite legal obligation to pay interest on bonds, but there is no definite commitment to pay dividends on common stock Therefore, if net income should drop substantially, bonds would be less desirable than common stock If the bonds are issued, there is a definite commitment to repay the principal in 20 years In case of liquidation, the claims of the bondholders would rank ahead of the claims of the common stockholders Present stockholders must purchase the new stock if they are to retain their proportionate control and financial interest in the corporation Since the net income has been relatively stable in the past and anticipated earnings under Plan offer earnings per share of $4.38 for each share of common stock, Plan appears to be somewhat more advantageous for stockholders CP 14–6 Year 3: 7.3 = $214,824 + $1,356,595 $214,824 Year 2: 5.9 = $237,025 + $1,155,894 $237,025 Year 1: 9.3 = $149,774 + $1,243,084 $149,774 The number of times interest charges are earned has decreased from Year to Year This was due to the company’s increasing interest expense during this period ... 14 11 2 014 Jan Cash Notes Paya Dec 31 Interest Expen Notes Payable Cash 2017 Dec 31 Interest Expen Notes Payable Cash *$46,813 – $10,665 CHAPTER 14 Long-Term Liabilities: Bonds and Notes Ex 14 12... $37,702,483 – $ 214, 876 d Annual interest paid……………………………………… Less premium amortized*………………………………… Interest expense for first year…………………………… * $ 214, 876 + $225,620 214, 876 225,620 CHAPTER 14 Long-Term... * $110,401 ÷ 10 semiannual payments PE 14 4A Cash Premium on Bonds Payable Bonds Payable PE 14 4B Cash Premium on Bonds Payable Bonds Payable 14- 3 © 2 014 Cengage Learning All Rights Reserved