Financial Analysis: Bonds and Long-Term Notes

Chapter 14   Bonds and Long-Term Notes

Some Solutions

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 14–1

Periodic interest is calculated as the effective interest rate times the amount of the debt outstanding during the period.  This same principle applies to the flip side of the transaction, that is, the creditor’s receivable or investment.  The approach also is the same regardless of the specific form of the debt, that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments.

Question 14–2

Long-term liabilities are appropriately reported at their present values.  The present value of a liability is the present value of its related cash flows—specifically the present value of the face amount of the debt instrument, if any, plus the present value of stated interest payments, if any.  Both should be discounted to present value at the effective (market) rate of interest at issuance.

Question 14–3

Bonds and notes are very similar.  Both typically obligate the issuing corporation to repay a stated amount (e.g., the principal, par value, face amount, or maturity value) at a specified maturity date.  In return for the use of the money borrowed, the company also agrees to pay interest to the lender between the issue date and maturity.  The periodic interest is a stated percentage of face amount.  In concept, bonds and notes are accounted for in precisely the same way.  

Normally a company will borrow cash from a bank or other financial institution by signing a promissory note.  Corporations, especially medium- and large- sized firms, often choose to borrow cash by issuing bonds and instead of borrowing from a lending institution, it borrows from the public.  A bond issue, in effect, breaks down a large debt into manageable parts ($1,000 units), which makes it more attractive to individual and corporate investors.  Also, bonds typically have longer maturities than notes.  The most common form of corporate debt is bonds.  

Question 14–4

All of the specific promises made to bondholders are described in a bond indenture.  This formal agreement will specify the bond issue’s face amount, the stated interest rate, the method of paying interest (whether the bonds are registered bonds or coupon bonds), whether the bonds are backed by a lien on specified assets, and whether they are subordinated to other debt.  The bond indenture also might provide for redemption through a call feature, by serial payments, through sinking fund provisions, or by conversion.  It also will specify the trustee (usually a commercial bank or other financial institution) appointed by the issuing firm to represent the rights of the bondholders.  The bond indenture serves as a contract between the company and the bondholder(s).  If the company fails to live up to the terms of the bond indenture, the trustee may bring legal action against the company on behalf of the bondholders.