4.4.2 Bonds
All bonds are ten year notes. Your company pays a 5% brokerage fee for issuing bonds. The first three digits of the bond, the series number, reflect the interest rate. The last four digits indicate the year in which the bond is due. The numbers are separated by the letter S which stands for “series.” For example, a bond with the number 12.6S2014 has an interest rate of 12.6% and is due December 31, 2014.
As a general rule, bond issues are used to fund long term investments in capacity and automation.
Bondholders will lend total amounts up to 80% of the value of your plant and equipment (the Production Department’s capacity and automation). Each bond issue pays a coupon, the annual interest payment, to investors. If the face amount or principal of bond 12.6S2014 were $1,000,000, then the holder of the bond would receive a payment of $126,000 every year for ten years. The holder would also receive the $1,000,000 principal at the end of the tenth year. Each year your company is given a credit rating that ranges from AAA (best) to D (worst). In Capstone, ratings are evaluated by comparing current debt interest rates with the prime rate.
When issuing new bonds, the interest rate will be 1.4% over the current debt interest rates. If your current debt interest rate is 12.1%, then the bond rate will be 13.5%.
You can buy back outstanding bonds before their due date. A 1.5% brokerage fee applies. These bonds are repurchased at their market value or street price on January 1 of the current year. The street price is determined by the amount of interest the bond pays and your credit worthiness. It is therefore different from the face amount of the bond. If you buy back bonds with a street price that is less than its face amount, you make a gain on the repurchase. This will be reflected as a negative write-off on the income statement (see “6.3 Income Statement”).
Bonds are retired in the order they were issued. The oldest bonds retire first. There are no brokerage fees for bonds that are allowed to mature to their due date.
If a bond remains on December 31 of the year it becomes due, your banker lends you current debt to pay off the bond principal. This, in effect, converts the bond to current debt. This amount is combined with any other current debt due at the beginning of the next year.
When Bonds Are Retired Early
A bond with a face amount of $10,000,000 could cost $11,000,000 to repurchase because of fluctuations in interest rates and your credit worthiness. A 1.5% brokerage fee applies. The difference between the face value and the repurchase price will reflect as a gain or loss in the income statement’s fees and write-offs.
When Bonds Come Due
Assume the face amount of bond 12.6S2014 is $1,000,000. The $1,000,000 repayment is acknowledged in your reports and spreadsheets in the following manner: Your annual reports from December 31, 2014 would reflect an increase in current debt of $1,000,000 offset by a decrease in long term debt of $1,000,000. The 2014 spreadsheet will list the bond because you are making decisions on January 1, 2014, when the bond still exists. Your 2015 spreadsheet would show a $1,000,000 increase in current debt and the bond no longer appears.
Bond Ratings
If your company has no debt at all, your company is awarded a AAA bond rating. As your debt-to-assets ratio increases, your current debt interest rates increase. Your bond rating slips one category for each additional 0.5% in current debt interest. For example, if the prime rate is 10% and your current debt interest rate is 10.5%, then you would be given a AA bond rating instead of a AAA rating.