Stockholders' Equity: Classes of Capital Stock

Read this chapter, which introduces long-term bonds, their value, how they compare with stock. Some companies expand using stock, while some use debt (bonds). The example exercises refer to Appendix A, which is included here.

Key terms

Annuity A series of equal cash flows spaced in time.

Bearer bond See unregistered bond.

Bond A long-term debt, or liability, owed by its issuer. A bond certificate, a negotiable instrument, is the formal, physical evidence of the debt owed.

Bond indenture The contract or loan agreement under which bonds are issued.

Bond redemption (or sinking) fund A fund used to bring about the gradual redemption of a bond issue.

Callable bond A bond that gives the issuer the right to call (buy back) the bond before its maturity date.

Call premium The price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.

Carrying value (of bonds) The face value of bonds minus any unamortized discount or plus any unamortized premium. Sometimes referred to as net liability on the bonds.

Compound interest Interest calculated on the principal and on interest of prior periods.

Contract rate of interest The interest rate printed on the bond certificates and specified on the bond indenture; also called the stated, coupon, or nominal rate.

Convertible bond A bond that may be exchanged for shares of stock of the issuing corporation at the bondholders' option.

Coupon bond A bond not registered as to interest; it carries detachable coupons that are to be clipped and presented for payment of interest due.

Debenture bond An unsecured bond backed only by the general creditworthiness of its issuer.

Discount (on bonds) Amount a bond sells for below its face value.

Effective interest rate method (interest method) A procedure for calculating periodic interest expense (or revenue) in which the first period's interest is computed by multiplying the carrying value of bonds payable (bond investments) by the market rate of interest at the issue date. The difference between computed interest expense (revenue) and the interest paid (received), based on the contract rate times face value, is the discount or premium amortized for the period. Computations for subsequent periods are based on the carrying value at the beginning of the period.

Face value Principal amount of a bond.

Favorable financial leverage An increase in EPS and the rate of return on stockholders' equity resulting from earning a higher rate of return on borrowed funds than the fixed cost of such funds. Unfavorable financial leverage results when the cost of borrowed funds exceeds the income they generate, resulting in decreased income to stockholders.

Future value or worth The amount to which a sum of money invested today will grow during a stated period of time at a specified interest rate.

Interest method See effective interest rate method.

Junk bonds High-interest rate, high-risk bonds; many were issued in the 1980s to finance corporate restructurings.

Market interest rate The minimum rate of interest investors will accept on bonds of a particular risk category. Also called effective rate or yield.

Mortgage A legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments. A bond secured by a mortgage is called a mortgage bond.

Premium (on bonds) Amount a bond sells for above its face value.

Present value The current worth of a future cash receipt(s); computed by discounting future receipts at a stipulated interest rate.

Registered bond A bond with the owner's name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar.

Secured bond A bond for which a company has pledged specific property to ensure its payment.

Serial bonds Bonds in a given bond issue with maturities spread over several dates.

Simple interest Interest on principal only.

Sinking fund See Bond redemption fund.

Stock warrant A right that allows the bondholder to purchase shares of common stock at a fixed price for a stated period of time. Warrants issued with long-term debt may be detachable or nondetachable.

Straight-line method of amortization A procedure that, when applied to bond discount or premium, allocates an equal amount of discount or premium to each period in the life of a bond.

Term bond A bond that matures on the same date as all other bonds in a given bond issue.

Times interest earned ratio Income before interest and taxes (IBIT) divided by interest expense. In complex situations, "operating income" is often used to represent IBIT.

Trading on the equity A company using its stockholders' equity as a basis for securing funds on which it pays a fixed return.

Trustee Usually a bank or trust company appointed to represent the bondholders and to enforce the provisions of the bond indenture against the issuer.

Underwriter An investment company or a banker that performs many tasks for the bond issuer in issuing. bonds; may also guarantee the issuer a fixed price for the bonds.

Unfavorable financial leverage Results when the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage.

Unregistered (bearer) bond Ownership transfers by physical delivery.

Unsecured bond A debenture bond, or simply a debenture.