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Chapter 11

MGAB02H3 Chapter Notes - Chapter 11: Zero-Coupon Bond, Premium Bond, Current Liability


Department
Financial Accounting
Course Code
MGAB02H3
Professor
Liang Chen
Chapter
11

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TOPIC 3: CH. 11 - REPORTING & INTERPRETING NON-CURRENT LIABILITIES
Non-current Liabilities: all of entity’s obligations not classified as current liabilities, >1 year.
Advantages of long-term debt:
1. Shareholders maintain control
. Debt doesn’t dilute ownership/control of company since
debtholders participate in neither management of operations nor in eventual distribution
of retained earnings to shareholders.
2. Interest expense is tax deductible
. Deductibility of interest for tax purposes reduces net
cost of borrowing. Advantage compared to dividends paid on shares that aren’t tax
deductible.
3. Impact on earnings is positive
. Money can often be borrowed a low interest and invested
at a higher rate.
Disadvantages with long-term debt:
1. Risk of bankruptcy
. Interest payments to debtholders must be made each period no
matter profit/loss.
2. Negative impact on cash flows
. Debt must be repaid at specific time in the future.
Management must be able to generate cash to repay or ability to refinance.
CHARACTERISTICS of Long-term Notes & Bonds Payable
Private Placement: raising debt from a
financial organization, including banks,
insurance companies, & pension funds.
Note Payable: written promise to pay
stated sum of money at one or more
specified future dates (maturity date).

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In cases when company’s needs for debt capital > financial capability of single creditor,
company issues publicly traded debt called bonds. Which is traded in markets that give
bondholders liquidity.
BONDS
Secured: when issuer has a pledge on a specific asset, collateral on the loan. Can secure
notes/bonds payable by using revenue, inventory, PPE.
Provides creditor with right to foreclose debt/repossess assets/collateral pledged in
contract
ex) if you don’t pay your loan, I get your BMW.
Unsecured: self-explanatory
Bond Principal: amount payable at maturity date & basis for computing periodic cash interest
payments. Also called the par value, face amount, or maturity value
.
Debenture: unsecured bond
; no assets
pledged.
Secured: assets
pledged.
Callable Bonds: may be called for early retirement by issuer
.
Retractable Bonds: may be turned in for early retirement by bondholder
.
Convertible Bonds: may be converted
to other securities
by issuer (ex) common shares).
When company decides to issue new bonds, it prepares a bond/trust or indenture: bond
contract specifying legal provisions of bond issues. It includes maturity date, interest,
date of each payment, and any conversion privileges.
Also contains covenants designed to protect creditors, such as: limitations on new debt
company might issue in future, limitations on dividend payments, and required min level
of acc. ratios like current ratio.
Also prepares a prospectus, describing company, the bonds, & how proceeds will be
used.
When bond is issued, investor receives a bond certificate. A trustee is an independent
party appointed to represent bondholders, duties are to ascertain whether issuing
company fulfills all provisions outlined. Senior Debt receives preference over other
creditors in event of bankruptcy/default, while Subordinated Debt is riskier than senior
debt.
PAYMENT Options:
Interest & principal paid at maturity
Instalment notes:

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Normally repayable in series
of periodic payments
called instalments
Instalment payments usually take one of two forms:
Fixed principal payments PLUS interest (fixed or floating interest)
Blended principal & interest payments
REPORTING Bond Transactions
Issue price of bond determined by the market, based on time value of money.
The interest rate used to compute the PV is the market interest rate.
The stated rate only used to compute
periodic interest payments
.
Interest = Principal * Stated Rate *
Time
Creditors demand a certain rate of
interest to compensate them for the
bond risks, the market interest rate
(or yield, effective-interest rate). It is the interest rate on
a debt when it is incurred.
PREMIUM = Coupon Rate > Market Rate, bond pays higher than market, so demand increases
& people willing to pay more.
PAR = Coupon Rate = Market Rate
DISCOUNT = Coupon Rate < Market Rate, bond pays interest lower than market, so demand
decreases & discount is provided (price decreases)
Bonds Issued at PAR
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