Bonds

1
Bonds

• Debenture bond - secured only by the "full faith
  and credit" of the issuing corporation. No
  specific assets are pledged as security.
• Mortgage bond - backed by a lien on specified
  real estate owned by the issuer.
• Subordinated debenture - not entitled to receive
  any liquidation payments until the claims of
  other specified debt issues are satisfied.
• Registered bond - interest checks are mailed
  directly to the owner, who is registered with
  the issuing company.
• Coupon bond - to collect interest the holder must
  actually clip an attached coupon and redeem it in
  accordance with instructions in the indenture.
• Callable (or redeemable) bonds - the call feature
  allows the issuing company to buy back, or
  "call", outstanding bonds from bondholders before
  their scheduled maturity date.
• Serial bonds - retired in installments over all
  or part of the life of the issue. Each bond has
  its own specified maturity date.
• Convertible bonds - retired as a consequence of
  bondholders choosing to convert them into shares
  of stock.

2
Bonds Sold at Face

• On January 1, 2000, Masterwear Industries issued
  700,000 of 12 bonds. Interest of 42,000 is
  payable semiannually on June 30 and December 31.
  The bonds mature in three years an
  unrealistically short maturity to shorten the
  illustration. The entire bond issue was sold in
  a private placement to United Intergroup, Inc. at
  face amount.
• At Issuance (January 1)
• Masterwear (Issuer)
• Cash 700,000 Bonds payable (face
  amount) 700,000United (Investor)Investment
  in bonds (face amount) 700,000 Cash 700,000

3
Bonds Issued Between Interest Dates

• All bonds sell at their price plus any interest
  that has accrued since the last interest date.
• Illustration - On March 1, 2000, Masterwear
  Industries issued 700,000 of 12 bonds, dated
  January 1. Interest of 42,000 is payable
  semiannually on June 30 and December 31. The
  bonds mature in three years. The entire bond
  issue was purchased by United Intergroup, Inc.
  for 700,000 plus 14,000 accrued interest.
• 700,000 x 12 x 2/12 14,000 face
  annual fraction of the accrued value
  rate annual
  period interest
• At Issuance (March 1)
• Masterwear (Issuer)
• Cash (price plus accrued interest)
  714,000 Bonds payable (face amount)
  700,000 Interest payable (accrued
  interest) 14,000
• United (Investor)Investment in bonds (face
  amount) 700,000Interest
  receivable (accrued interest) 14,000 Cash
  (price plus accrued interest)
  714,000

4
Determining the Selling Price

• A bond issue will be priced by the marketplace to
  yield the market rate of interest for securities
  of similar risk and maturity.
• Illustration - On January 1, 2000, Masterwear
  Industries issued 700,000 of 12 bonds, dated
  January 1. Interest is payable semiannually on
  June 30 and December 31. The bonds mature in
  three years. The market yield for bonds of
  similar risk and maturity is 14. The entire
  bond issue was purchased by United Intergroup,
  Inc.
• Present value (price) of the bonds Present
  Values
• Interest 42,000 x 4.76654
  200,195
• Principal 700,000 x 0.66634 466,438
• Present value (price) of the bonds 666,633
• present value of an ordinary annuity of 1
  n6, i7 (Table 6-4)
• present value of 1 n6, i7 (Table 6-2)

5
Determining Interest - Effective Interest Method

• Interest accrues on an outstanding debt at a
  constant percentage of the debt each period.
  Interest each period is recorded as the effective
  market rate of interest multiplied by the
  outstanding balance of the debt (during the
  interest period).
• Continuing the previous example, interest
  recorded (as expense to the issuer and revenue to
  the investor) for the first six-month interest
  period is 46,664
• 666,633 x 14 2 46,664
• Outstanding Balance Effective Rate
  Effective Interest

6
Amortization Schedule - Discount

• Effective
  Increase in Outstanding
• Interest
  Balance Balance
• 666,633
• 1 .07 (666,633) 42,000 4,664 671,297
• 2 .07 (671,297) 42,000 4,991 676,288
• 3 .07 (676,288) 42,000 5,340 681,628
• 4 .07 (681,628) 42,000 5,714 687,342
• 5 .07 (687,342) 42,000 6,114 693,456
• 6 .07 (693,456) 42,000 6,544 700,000

7
Debt Issue Costs

• With either publicly or privately sold debt, the
  issuing company will incur costs in connection
  with issuing bonds or notes, such as legal and
  accounting fees and printing costs in addition to
  registration and underwriting fees. These debt
  issue costs are recorded separately and are
  amortized over the term of the related debt.

8
Installment Notes

• Notes often are paid in installments, rather than
  a single amount at maturity.
• Each payment includes both an amount that
  represents interest and an amount that represents
  a reduction of principal.
• 666,633 4.76654
  139,857 amount (from Table
  6A-4) installment of loan n6,
  i7.0 payment
• Effective
  Decrease in
  OutstandingCash Interest
  Balance
  Balance 7 x Outstanding Debt
• 666,633
• 1 139,857 .07 (666,633) 46,664 93,193 573,440
• 2 139,857 .07 (573,440) 40,141 99,716 473,724
• 3 139,857 .07 (473,724) 33,161 106,696 367,028
• 4 139,857 .07 (367,028) 25,692 114,165 252,863
• 5 139,857 .07 (252,863) 17,700 122,157 130,706
• 6 139,857 .07 (130,706) 9,151 130,706 0
• 839,142 172,509 666,633

9
Troubled Debt Restructuring

• When changing the original terms of a debt
  agreement is motivated by financial difficulties
  experienced by the debtor (borrower), the new
  arrangement is referred to as a troubled debt
  restructuring. By definition, a troubled debt
  restructuring involves some concessions on the
  part of the creditor (lender). A troubled debt
  restructuring may be achieved in either of two
  ways
• (a) The debt may be settled at the time of the
  restructuring, or
• (b) The debt may be continued, but with modified
  terms.

10
DERIVATIVES

• Derivatives are financial instruments that
  derive their values or contractually required
  cash flows from some other security or index.
• Derivative financial instruments have become
  the key tools of risk management.
• The most frequently used derivatives are
• o Financial futures
• o Forward contracts
• o Options
• o Interest rate swaps
• Derivatives can manage or hedge companies
  exposures to risk, including interest rate risk,
  price risk, and foreign exchange risk.

11
DERIVATIVES USED TO HEDGE RISK

• Hedging means taking a risk position that is
  opposite to an actual position that is exposed to
  risk.
• The effectiveness of a hedge is influenced by
  the closeness of the match between the item being
  hedged and the financial instrument chosen as a
  hedge.
• A futures contract allows a firm to sell (or
  buy) a financial instrument at a designated
  future date, at todays price.
• A forward contract is similar to a futures
  contract but does not call for a daily cash
  settlement for price changes in the underlying
  contract. Gains and losses on forward contracts
  are paid only when they are closed out.
• An option gives its holder the right either to
  buy or to sell an instrument, say a Treasury
  bill, at a specified price and within a given
  time period.

12
ACCOUNTING FOR DERIVATIVES

• All derivatives, no exceptions, are carried on
  the balance sheet as either assets or liabilities
  at fair value.
• When the fair value changes, a gain or loss
  occurs.
• How we account for the gain or loss depends on
  how the derivative is used.
• 1. If the derivative is not designated as a
  hedging instrument, or doesnt qualify as one,
  the gain or loss is recognized immediately in
  earnings.
• 2. If the derivative is used to hedge against
  exposure to risk, the gain or loss is either
• recognized immediately in earnings along with
  an offsetting loss or gain on the item being
  hedged or
• deferred in comprehensive income until it can
  be recognized in earnings at the same time as
  earnings are affected by a hedged transaction.
• Which way depends on whether the derivative is
  designated as a (a) fair value hedge, (b) cash
  flow hedge, or (c) foreign currency hedge.

13
Fair Value Hedges

• A change in either prices or interest rates can
  cause a change in the fair value of an asset, a
  liability, or a commitment to buy or sell assets
  or liabilities.
• If a derivative is used to hedge against the
  exposure to changes in the fair value, it can be
  designated as a fair value hedge.
• A gain or loss from a fair value hedge is
  recognized immediately in earnings along with the
  loss or gain from the item being hedged.
• o When the derivative is adjusted to reflect
  changes in fair value, the other side of the
  entry is recognized as a gain or loss to be
  included currently in earnings.
• o At the same time, the loss or gain from changes
  in the fair value (due to the risk being hedged)
  of the item being hedged also is included
  currently in earnings.
• o So, to the extent the hedge is effective, the
  gain or loss on the derivative will be offset by
  the loss or gain on the item being hedged.

14
CASH FLOW HEDGES

• If a derivative is used to hedge against
  exposure to changes in cash inflows or outflows
  of an asset or liability or a forecasted
  transaction, it can be designated as a cash flow
  hedge.
• When the derivative is adjusted to reflect
  changes in fair value, the other side of the
  entry is recognized as a gain or loss to be
  deferred as a component of other comprehensive
  income - included in earnings later, at the same
  time as earnings are affected by the hedged
  transaction.
• Comprehensive income includes net income itself
  and changes in elements of the balance sheet that
  the FASB feels dont (yet) belong in net income
  
• o foreign currency translation adjustments
• o unrealized gains and losses on
  available-for-sale securities
• o minimum pension liability adjustments
• The portion of the gain or loss due to
  ineffective hedging is reported in earnings
  immediately.

15
FOREIGN CURRENCY HEDGES

• The possibility that foreign currency exchange
  rates might change exposes many companies to
  foreign currency risk.
• A foreign currency hedge can be a hedge of
  foreign currency exposure of
• a firm commitment - treated as a fair value
  hedge.
• an available-for-sale security - treated as a
  fair value hedge.
• a forecasted transaction - treated as a cash
  flow hedge.
• a company's net investment in a foreign
  operation - the gain or loss is reported in other
  comprehensive income as part of the cumulative
  translation adjustment.