Bonds represent a liability to the corporation that issues the bonds and an asset to a company that buys the bonds as an investment. Each side of the transaction is the mirror image of the other.1 This is demonstrated in Illustration 14-1.
Bonds Sold at Face Amount
On January 1, 2011, 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 the face amount.
Most bonds these days are issued on the day they are dated (date printed in the indenture contract). On rare occasions, there may be a delay in issuing bonds that causes them to be issued between interest dates, in which case the interest that has accrued since the day they are dated is added to the bonds' price. We discuss this infrequent event in an appendix to this chapter.
Determining the Selling Price
The price of a bond issue at any particular time is not necessarily equal to its face amount. The $700,000, 12% bond issue in the previous illustration, for example, may sell for more than face amount (at a premium arises when bonds are sold for more than face amount.) or less than face amount (at a discount arises when bonds are sold for less than face amount.), depending on how the 12% stated interest rate compares with the prevailing market or effective rate of interest (for securities of similar risk and maturity). For instance, if the 12% bonds are competing in a market in which similar bonds are providing a 14% return, the bonds could be sold only at a price less than $700,000. On the other hand, if the market rate is only 10%, the 12% stated rate would seem relatively attractive and the bonds would sell at a premium over face amount. The reason the stated rate often differs from the market rate, resulting in a discount or premium, is the inevitable delay between the date the terms of the issue are established and the date the issue comes to market.
In addition to the characteristic terms of a bond agreement as specified in the indenture, the market rate for a specific bond issue is influenced by the creditworthiness of the company issuing the bonds. To evaluate the risk and quality of an individual bond issue, investors rely heavily on bond ratings provided by Standard & Poor's Corporation and by Moody's Investors Service, Inc. See the bond ratings in Graphic 14-1.
*Adapted from Bond Record (New York: Moody's Investors Service, monthly) and Bond Guide (New York: Standard & Poor's Corporation, monthly).
Other things being equal, the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command.
Forces of supply and demand cause a bond issue to be priced to yield the market rate. In other words, an investor paying that price will earn an effective rate of return on the investment equal to the market rate. The price is calculated as the present value of all the cash flows required of the bonds, where the discount rate used in the present value calculation is the market rate. Specifically, the price will be the present value of the periodic cash interest payments (face amount × stated rate) plus the present value of the principal payable at maturity, both discounted at the market rate.
Bonds priced at a discount are described in Illustration 14-2.
A bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity.
Bonds Sold at a Discount
On January 1, 2011, 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 market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc.
*Present value of an ordinary annuity of $1: n = 6, i = 7% (Table 4).
†Present value of $1: n = 6, i = 7% (Table 2).
Because interest is paid semiannually, the present value calculations use: (a) one-half the stated rate (6%) to determine cash payments, (b) one-half the market rate (7%) as the discount rate, and (c) six (3 × 2) semiannual periods.
Note: Present value tables are provided at the end of this textbook. If you need to review the concept of the time value of money, refer to the discussions in .
Rounding: Because present value tables truncate decimal places, the solution may be slightly different if you use a calculator or Excel.
The calculation is illustrated in Graphic 14-2:
Cash Flows from a Bond Issue
Although the cash flows total $952,000, the present value of those future cash flows as of January 1, 2011, is only $666,633. This is due to the time value of money. These bonds are issued at a discount because the present value of the cash flows is less than the face amount of the bonds.
Journal Entries at Issuance—Bonds Sold at a Discount
When bond prices are quoted in financial media, they typically are stated in terms of a percentage of face amounts. Thus, a price quote of 98 means a $1,000 bond will sell for $980; a bond priced at 101 will sell for $1,010.