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Chapter14: Bonds and Long-Term Notes

Bonds with Detachable Warrants

Another (less common) way to sweeten a bond issue is to include detachable stock purchase warrants the investor has the option to purchase a stated number of shares of common stock at a specified option price, within a given period of time. as part of the security issue. A stock warrant gives the investor an option to purchase a stated number of shares of common stock at a specified option price, often within a given period of time. Like a conversion feature, warrants usually mean a lower interest rate and often enable a company to issue debt when borrowing would not be feasible otherwise.

   However, unlike the conversion feature for convertible bonds, warrants can be separated from the bonds. This means they can be exercised independently or traded in the market separately from bonds, having their own market price. In essence, two different securities—the bonds and the warrants—are sold as a package for a single issue price. Accordingly, the issue price is allocated between the two different securities on the basis of their market values. If the independent market value of only one of the two securities is reliably determinable, that value establishes the allocation. This is demonstrated in Illustration 14-7.

The issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their market values.

p. 773

ILLUSTRATION 14-7
Bonds with Detachable Warrants

On January 1, 2011, HTL Manufacturers issued $100 million of 8% debentures due 2018 at 103 (103% of face value). Accompanying each $1,000 bond were 20 warrants. Each warrant permitted the holder to buy one share of no par common stock at $25 per share. Shortly after issuance, the warrants were listed on the stock exchange at $3 per warrant.

($ in millions)

Cash (103% × $100 million) ........................................

103

Discount on bonds payable (difference) ..........................

3

 Bonds payable (face amount) ....................................

100

    Equity—stock warrants* ........................................

6

  
ADDITIONAL CONSIDERATION

Market imperfections may cause the separate market values not to sum to the issue price of the package. In this event, allocation is achieved on the basis of the relative market values of the two securities. Let's say the bonds have a separate market price of $940 per bond (priced at 94):

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Proportion of Issue Price Allocated to Bonds:

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Proportion of Issue Price Allocated to Warrants:

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($ in millions)

Cash (103% × $100 million) .................................

103.00

Discount on bonds payable ($100 million − $96.82 million) .....

3.18

    Bonds payable (face amount) ......................

100.00

    Equity—stock warrants (to balance) .................

6.18

   Notice that this is the same approach we used in Chapter 10 to allocate a single purchase price to two or more assets bought for that single price. We also will allocate the total selling price of two equity securities sold for a single issue in proportion to their relative market values in Chapter 18.

  

   If one-half of the warrants (1 million) in Illustration 14-7 are exercised when the market value of HTL's common stock is $30 per share, 1 million shares would be issued for one warrant each plus the exercise price of $25 per share.

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Journal Entry at Exercise of Detachable Warrants

p. 774

   The $30 market value at the date of exercise is not used in valuing the additional shares issued. The new shares are recorded at the total of the previously measured values of both the warrants and the shares.

CONCEPT REVIEW EXERCISE

ISSUANCE AND EARLY EXTINGUISHMENT OF DEBT

The disclosure notes to the 2011 financial statements of Olswanger Industries included the following:


Note 12: Bonds

      

On September 15, 2010, the Corporation sold bonds with an aggregate principal amount of $500,000,000 bearing a 14% interest rate. The bonds will mature on September 15, 2020, and are unsecured subordinated obligations of the Corporation. Interest is payable semiannually on March 15 and September 15. The Corporation may redeem the bonds at any time beginning September 15, 2010, as a whole or from time to time in part, through maturity, at specified redemption prices ranging from 112% of principal in declining percentages of principal amount through 2017 when the percentage is set at 100% of principal amount. The cost of issuing the bonds, totaling $11,000,000, and the discount of $5,000,000 are being amortized over the life of the bonds, using the straight-line method and the interest method, respectively. Amortization of these items for the year ended December 31, 2011, was $960,000 and $252,000, respectively.

      
      

During the year ended December 31, 2011, the Corporation repurchased, in open market transactions, $200,000,000 in face amount of the bonds for $219,333,000. The unamortized cost of issuing these bonds and the unamortized discount, $3,972,000 and $1,892,000, respectively, have been deducted in the current period.

      

From the information provided by Olswanger in Note 12, you should be able to recreate some of the journal entries the company recorded in connection with this bond issue.

Required:

1.

 

Prepare the journal entry for the issuance of these bonds on September 15, 2010.

2.

 

Prepare the journal entry for the repurchase of these bonds, assuming the date of repurchase was September 15, 2011. The cash paid to repurchase the bonds was $219,333,000.

SOLUTION

1.

 

Prepare the journal entry for the issuance of these bonds on September 15, 2010.

($ in 000s)

Cash (to balance) .................

484,000

Bond issue costs (given in note) ...............

11,000

Discount on bonds payable (given in note) ......................

5,000

    Bonds payable (face amount—given in note) ............

500,000

2.

 

Prepare the journal entry for the repurchase of these bonds, assuming the date of repurchase was September 15, 2011.

($ in 000s)

Bonds payable (face amount repurchased) ....................

200,000

Loss on early extinguishment (to balance) ..................

25,197

    Discount on bonds payable (given in note) .......

1,892

    Bond issue costs (given in note) ...............

3,972

    Cash (given in requirement 2) ...............

219,333




*Reported as part of shareholders' equity rather than as a liability.

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