Long-Term Financing - Bonds

Summary :

This chapter describes the features of bonds and how they differ from stock, and the advantages and disadvantages of financing with long-term debt, including financial leverage. It covers pricing a bond using present value, recording bonds issued at face value, at a discount, or at a premium, bond redemptions and conversions, and bond ratings.

Bonds compared with stock

A bond is a formal promise to pay a stated amount at a future maturity date plus periodic interest, which makes it fundamentally different from stock: interest is a fixed, tax-deductible obligation regardless of company earnings, while dividends are discretionary and paid only after taxes. Financing with long-term debt can amplify returns to shareholders through financial leverage when the return earned on borrowed funds exceeds their interest cost, but it also raises fixed obligations the company must meet even in a poor year.

Pricing and recording bonds

A bond's issue price is found by applying the concept of present value to its future interest payments and maturity amount, discounted at the market rate of interest; when the market rate differs from the bond's stated rate, the bond sells at a discount or a premium rather than at face value. The chapter shows the journal entries required in each case, at issuance and as interest is recorded, as well as the entries for bonds issued exactly at face value.

Redemptions, conversions, and ratings

Bonds can be redeemed before maturity or converted into shares of stock under terms set when they were issued, each requiring its own set of journal entries to remove the bond liability and recognize any resulting gain or loss. Independent rating agencies assign bond ratings that signal a company's creditworthiness to investors, and the times interest earned ratio, which relates income before interest and taxes to interest expense, measures how comfortably a company can meet its interest obligations.