ACCT 2610 Lecture 15: Reporting and Interpreting Bonds

4 Pages
Unlock Document

Accounting ACCT 2610
Lemayian Zawadi

Lecture 18-19: Reporting and Interpreting Bonds I. Bonds A. Basics 1. Capital Structure a. The capital structure of a company is the mixture of debt and equity a company uses to finance its operations b. Two ways that a company can borrow money are • Private placement: Money is borrowed from a specific bank or banks • Public issuance (Bonds): Money is borrowed from investors c. A bond is a security that a corporation or governmental agency issues when they borrow a large amount of money • Typically, bonds are sold to a large number of entities or individuals • Can be traded on an exchange, which help to provide added liquidity to the holders of the bonds 2. Advantages of Issuing Bonds a. Stockholders maintain control • Bondholders do not vote or share in the company’s earnings b. Interest expense is tax-deductible • The tax deductibility of interest expense reduces the net cost of borrowing • Dividends are not tax deductible c. The impact on earnings is generally positive • If the money can be borrowed at a lower interest rate and reinvested at a higher interest rate, then the impact on earnings is positive 3. Disadvantages of Issuing Bonds a. Risk of bankruptcy increases • Interest payments are fixed charges that must be paid each period whether or not the company is profitable b. Negative impact on cash flows • Debt has to be paid back at a specific time in the future • The company needs to generate sufficient cash flows to pay back the principal and interest 4. Different Types of Bonds a. Because investors have different risk and return preferences, there are different types of bonds to attract different types of investors b. Unsecured Bonds = no assets are pledged as a guarantee of repayment at maturity • Would demand high interest rates here since there is risk and high reward c. Secured bonds = specific assets are pledged as a guarantee of repayment at maturity • Lower interest rates since less risk involved d. Callable Bonds = bond may be called for early retirement by the issuer • Would demand higher interest rate because of risk of ending early, • Company likes this because they may be able to borrow cheaper later, so they can pay off and buy out then borrow at lower rate e. Convertible Bonds = bond may be converted to common stock of the issuer 5. Cash Payment of Bonds a. Two types of cash paid in bond contract: • Principal (also called face value or par value) • Cash interest payments (stated rate * principal) b. Principal is also known as face value, face amount, & par value c. Stated Rate is also known as coupon rate & contract rate 6. Bond Issuance and Documents a. A bond indenture (contract) is a document prepared when the company decides to issue bonds • Specifies the legal provisions of the bonds: maturity date, stated rate, date of interest payments (usually paid quarterly, semi-annually, or annually), conversion privileges • Specifies debt covenants b. A debt covenant is an agreement between company and creditors designed to protect the creditors • Limitations on company actions: E.g., limitation on future debt issuances or payment of dividends • Maintaining of specific ratios: E.g., current ratio must be equal to or greater than a previously specified value • Typically disclosed in the 10-k c. A prospectus is prepared by the bond issuer and given to potential bond investors • A prospectus describes: company, bonds, how the bond proceeds will be used d. A bond certificate is a document certifying debt owed • A bond certificate is received by the person or organization who purchases the bond • Ex: • Typically issued in 1,000 dollar increments • All certificates for a single bond issue are the same 7. Post-Issuance Evaluation a. Default risk is the probability that the bond issuer will not be able to meet the requirements specified in the indenture b. Bond-rating agencies (e.g., Moody’s and Standard & Poor’s ) exist to evaluate default risk • Investment grade bonds have ratings above Baa (Moody’s)/BBB (Standard & Poor’s) • Junk bonds have ratings below Baa/BBB: are speculative in nature, and cannot be held by many banks, mutual funds, and trusts B. Bond Buying and Selling 1. Selling Bonds a. Despite the bond’s face value, the bond issuer does not determine the selling price of the bond b. The market rate (a.k.a., yield, effective-interest rate) is the rate of interest demanded by creditors to compensate them for risks associated with holding the bonds, • The market rate is also the current rate of interest on a debt when incurred c. The market rate doesn’t have to be the same as the stated rate, most of the time it’s not • The ma
More Less

Related notes for Accounting ACCT 2610

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.