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[NOISE] The second type of liabilities

Â we are going to talk about today

Â is long term liabilities.

Â Under long term liabilities we are talking about obligations

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

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

Â Valuation of long term liabilities is quite complicated.

Â Under long term liabilities,

Â we need to calculate present value of all future obligations.

Â Present value's a very important topic.

Â It's the topic of corporate finance.

Â It's a long topic.

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

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

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

Â I'm going to discuss this soon.

Â 0:56

Probably the most important type of long term liability

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

Â So what's a bond?

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

Â borrower borrows some money from the lender.

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

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

Â we call this periodic payments as coupon payments.

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

Â so they are paid semi-annually.

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

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

Â we call this origin amount of borrowing as principal.

Â So one more time what's a bond?

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

Â periodic payments, so these are coupon payments and

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

Â Bonds are very interesting instruments just like stocks,

Â they are traded in the market.

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

Â 2:07

Whenever you become a bond holder of a firm,

Â you are going to get bond certificate.

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

Â First you are going to have information about maturity date.

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

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

Â It is a between the borrower and the lender.

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

Â value, which is the principal.

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

Â certificate.

Â And finally, when you are a bond holder,

Â you will have information about coupon rates.

Â Coupon rates are annual interest rates.

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

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

Â So how do you price bonds?

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

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

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

Â then we need to sum them up.

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

Â It is also a topic of corporate finance.

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

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

Â these are par bonds.

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

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

Â Take the value, the original amount of borrowing.

Â So there is no present value calculations for par bonds.

Â Is par bonds a big deal?

Â It is.

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

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

Â 3:52

So, how do do the accounting for bonds?

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

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

Â As you might remember we are talking about par bonds.

Â Under par bonds what do we have?

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

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

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

Â Obviously, the third borrows money.

Â There is a cash infusion, cash will go up.

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

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

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

Â face value is $5,000.

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

Â Issue date of this bond is January 1, 2015.

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

Â So what is the accounting at the time of issuance.

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

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

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

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

Â we didn't calculate any present value.

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

Â Okay?

Â Now we did the accounting for issues.

Â So how do we do the accounting after this time,

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

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

Â First there will be period coupon payments.

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

Â because you are paying some interest.

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

Â So how do we do this?

Â We issued this bond January 1, 2015, and

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

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

Â 2015, we need to pay some coupons.

Â What is the size of this coupon payment?

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

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

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

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

Â every six months is $250.

Â It is paid to lenders.

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

Â and notice that it is also $250.

Â It is in parentheses, it is an expense.

Â So what happens next?

Â One more six months pass.

Â Now, we are at end of year 2015.

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

Â the transaction will be similar.

Â Again, there is a cash reduction of $250,

Â and again there is an interest expense of $250.

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

Â Being though that the coupons are paid semi-annually,

Â it means that you need to pay ten coupons.

Â 7:05

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

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

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

Â you need to pay all original amount of borrowing.

Â So how are we going to do this?

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

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

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

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

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

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

Â We are at the time of maturity.

Â At the time of maturity,

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

Â How are we going to do this?

Â There is a cash reduction of $5,000,

Â and similarly notice that bond payable account is removed.

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

Â So from now on bond payable account disappears.

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

Â Where bond accounting involves two things.

Â You need to make coupon payments.

Â You need to record them.

Â And at end of the maternity,

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

Â