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[NOISE] The second type of liabilities

we are going to talk about today

is long term liabilities.

Under long term liabilities we are talking about obligations

that needs to be fulfilled by a firm in a time period more than one year.

What are some examples, bonds, long term bank loans are some examples.

Valuation of long term liabilities is quite complicated.

Under long term liabilities,

we need to calculate present value of all future obligations.

Present value's a very important topic.

It's the topic of corporate finance.

It's a long topic.

Therefore in this class, we are going to take a shortcut.

The shortcut is that we are going to talk about a particular type of a long-term

liability where you don't have to calculate present values.

I'm going to discuss this soon.

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Probably the most important type of long term liability

that we're going to talk about in this class is bonds.

So what's a bond?

Bond is a loan where there's a borrower and lender, and

borrower borrows some money from the lender.

In return, borrower commits two types of payments to the lender.

First, borrower makes some periodic payments to the lender, and

we call this periodic payments as coupon payments.

Most of the time these payments are made in every six months,

so they are paid semi-annually.

And second, the borrower pays at the end of the life of this bond,

which we call as maturity, all of the origin amount of borrowing,

we call this origin amount of borrowing as principal.

So one more time what's a bond?

It's a loan, and because of this loan the borrower pays lender two things,

periodic payments, so these are coupon payments and

repayment of all of the principle at the end of the maturity of the bond.

Bonds are very interesting instruments just like stocks,

they are traded in the market.

So, basically you can go ahead and buy a bond and become a bond holder of a firm.

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Whenever you become a bond holder of a firm,

you are going to get bond certificate.

On the bond certificate you will have information about at least three things.

First you are going to have information about maturity date.

In other words, what is the life of this bond?

Bonds can be issued for five years, 10 years, 15, 20.

It is a between the borrower and the lender.

The second information that you will get when you have a bond certificate is face

value, which is the principal.

It is the amount of original borrowing that's going to be written on the bond

certificate.

And finally, when you are a bond holder,

you will have information about coupon rates.

Coupon rates are annual interest rates.

They are quoted annually, but most of the time they are paid semi-annually.

I'm going to make an example about this soon, to make it much more.

So how do you price bonds?

Bond are price according to present value, because they are long-term liabilities.

So under bond pricing we need to calculate present value of future coupon payments.

We need to also calculate present value of repayment of the principle, and

then we need to sum them up.

But as I've mentioned before, present value calculation is a long topic.

It is also a topic of corporate finance.

In this class, we're going to take a shortcut.

That shortcut is that I'm going to talk about a particular type of bonds,

these are par bonds.

Under par bonds, you do not have to calculate present values.

Under par bonds, the head bonds, the price of the bond is equal to its face value.

Take the value, the original amount of borrowing.

So there is no present value calculations for par bonds.

Is par bonds a big deal?

It is.

In fact, if you look at the market, most of the bonds are issued at par.

So basically by looking at par bonds, we are not really losing much information.

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So, how do do the accounting for bonds?

Well, first of all we need to issue bonds, and

we need to go through accounting at the time of issues.

As you might remember we are talking about par bonds.

Under par bonds what do we have?

We have a price of a bond, which is equal to face value.

And similarly we have a bond payable, which is equal to bond face value.

So, at the time of issuance what type of accounting we are going to do?

Obviously, the third borrows money.

There is a cash infusion, cash will go up.

At the same time, the borrower will create a bond payable.

And who's amount will be same as face value.

Let's see an example. Here we have a firm issuing a bond who's

face value is $5,000.

The coupon rate is 10%, but it is going to be paid semi-annually, so every 6 months.

Issue date of this bond is January 1, 2015.

And the life of this bond is five years so the maturity will be five years.

So what is the accounting at the time of issuance.

Obviously at the time of issuance, which is January 1, 2015,

the firm generates $15,000, therefore, cash increases by $15,000.

Similarly, there is a bond payable account created, it also $15,000.

Notice here that we are talking about par bonds, therefore,

we didn't calculate any present value.

All we are doing here is that bond payable amount is same as the face value.

Okay?

Now we did the accounting for issues.

So how do we do the accounting after this time,

because we know that we are dealing with a bond, which is has a life of five years.

Well, we know that bonds have two types of payments.

First there will be period coupon payments.

Under period of coupon payments there will be a reduction from the cash,

because you are paying some interest.

And then you need to record some interest expense on the income statement.

So how do we do this?

We issued this bond January 1, 2015, and

we know that this bond has a coupon rate of 10%, which is paid semi-annually.

Therefore, at the end of the first 6 months, which is June 30,

2015, we need to pay some coupons.

What is the size of this coupon payment?

But we know that face value of this bond is $5,000.

We know that annual coupon rate is 10%, but we know that this

coupon are paid semi-annually, therefore I am dividing this by 2.

And if you do this calculations, you will find that the coupon payment for

every six months is $250.

It is paid to lenders.

And at the same time, we create an interest expense on the income statement,

and notice that it is also $250.

It is in parentheses, it is an expense.

So what happens next?

One more six months pass.

Now, we are at end of year 2015.

Therefore, we need to pay back one more coupon, and

the transaction will be similar.

Again, there is a cash reduction of $250,

and again there is an interest expense of $250.

And you are going to do this for the next five years.

Being though that the coupons are paid semi-annually,

it means that you need to pay ten coupons.

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Then what is the bond they can get at the time of maturity?

Well, at the time of maturity, you need to do two transactions.

First, you need to pay the last coupon and second,

you need to pay all original amount of borrowing.

So how are we going to do this?

Again, if I'll go back to my question, I have a bond whose face value is 5,000.

A new coupon rate of 10%, it has a life of five years, so

this firm will make 10 coupon payments, and if you look at the last row here,

at the end of 2019 I'm going to make the last coupon payments.

There is a cash reduction of $250, there is also an interest expense

on the income state of $ 250, but now we are at the end of this bond.

We are at the time of maturity.

At the time of maturity,

then the borrower needs to pay back all $5,000 back to the borrower.

How are we going to do this?

There is a cash reduction of $5,000,

and similarly notice that bond payable account is removed.

We put a minus $5,000 on the bond table.

So from now on bond payable account disappears.

So if you summarize, how do we do the bond accounting.

Where bond accounting involves two things.

You need to make coupon payments.

You need to record them.

And at end of the maternity,

you need to also record the payment of the original amount of face value.