MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS. Baginski & Hassell. Chapter 3. FINANCING DECISIONS: DEBT. Financing Decisions - Debt. Topics Characteristics of debt securities Cash interest versus effective interest Effective interest overview Computation of effective interest
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Baginski & Hassell
Example: On January 1, 2004, the Liu Co. issued $10,000,000 of 10 year, 8% bonds due January 1, 2014, with interest to be paid annually on January 1. (Liu will disburse “cash” interest of $800,000 each year, on January 1, starting on January 1, 2005.)
– The market rate of interest for debt (on the date of transaction), being a function of economy-wide conditions and borrower-specific risk factors.
Mathematics of Finance (in general) is based on five variables:
n = Number of interest payment periods
P= Principal (present value) - the amount being borrowed
MV = Maturity (future) value of the debt
R = “Rent” (generic term) payments on “rented” capital, i.e., the interest payment per period (n) and ...
Note: Investors compare investment opportunities by
comparing respective rates of return available, by calculating effective rates per year. For example, a stated rate of “8%, compounded semiannually” equates to an effective rate per year of 8.16%.
Typically, if three of the variable factors are “given” (known), financial calculators aid in easily deriving the other two; an example relating to bonds (wherefour “givens” are needed), follows.
The focus of such problems is very often the effective interest rate being earned per period or per year.
The present value of future cash interest annuityPLUS the present value of the future maturity value, both “discounted” by using the current market rate of interest for similar debts.
PV = $9,358,234; MV = $10,000,000
n = 10; R = $800,000 ($10,000,000 × 8%)
i = ? = 9%
(*) This principle applies to any acquisition of bonds from any seller, just as it applied to the original issuer involved.
This traditional procedure is “fair to all.” Why?
Beginning of the period carrying (book) value
× Historical effective interest rate at time of issuance
× appropriate time frame
= Interest expense
–Interest paid (or payable)
= Premium/discount amortization for the period
Facts: On January 1, 2004, the Faulconer Co. issued (for $4,550,000) the following bond: $4,000,000 of 7-year, 8% bonds, due January 1, 2011; interest is paid semiannually (on July 1 and January 1) each year. Faulconer incurred $75,000 in transactions costs.
Note: Any bond issue costs are recorded separately and amortized over the life of the bond.
n = 14; (7=year bonds × 2 semiannual periods)
R = interest payment per period = $160,000; ($4,000,000 × 8% × one-half year)
PV (present value) = purchase price = $4,550,000
MV in the future = face value = $4,000,000
i per n = ? = 2.8%
(*) Interest will be paid on July 1.
EXAMPLE: On January 1, 2004, the Lopez Co. issued at face value of $5,000,000 of 8-year, 10% convertible debentures, due January 1, 2012. Interest is paid annually on December 31. Each $1,000 bond is convertible into 30 shares of Lopez’s $10 par common stock at the option of the holder. On January 1, 2006 (after payment of the December 31, 2005, interest payment), all bonds were converted to common stock.
The balance sheet presentation just before and just after the conversion is as follows:
What would be the impact on the journal entry if the FMV of the common stock in the above example at the time of conversion was $25 per share? $35 per share?
How would premiums/discounts affect it?
Give it a shot!