Tag Archives | Interest

Zero Coupon Bonds

See Also:
What is a Bond
Non-Investment Grade Bonds
Covenant Definition of a Bond Contract
Yield to Maturity of a Bond
Financial Instruments

Zero Coupon Bonds

Zero coupon bonds are a debt security that does not have periodic interest payments. The bond, issued at a deep discount from par value, compensates for the lack of interest payments. Then they are redeemed at par value at maturity.

Stripped Bond

Banks or dealers create strip bonds, synthetic zero-coupon bonds. Therefore, separate the principal amount (the corpus) from the interest payments (the coupon payments) and sell the two parts separately to investors. Thus, this creates zero-coupon bonds. The investors then receive a lump sum at the maturity date, equal to the value of corpus or the coupon payments, depending on their contract. The contracts are known as STRIPS (Separate Trading of Registered Interest and Principal of Securities).

Imputed Interest

According to the IRS, the holder of a zero-coupon bond owes income tax on the bond’s imputed interest. Imputed interest refers to the implied periodic interest payments that the bondholder does not actually receive until maturity. Imputed interest on zero-coupon bonds issued by municipalities is tax exempt.

zero coupon bonds

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Sukuk

Sukuk Definition

A Sukuk is the islamic world’s version of a bond. It is also referred to as an islamic bond. Because Islamic people do not believe in charging or paying interest, they have been forced to maneuver their way around interest by renting certain assets or by taking ownership in a project.

Sukuk Meaning

A Sukuk structure is slightly different, but the principle is the same as a western bond. When a bank invests in a Sukuk or islamic bond, it is considered to be an investment in a certain project or asset that a company is working on. As the project or asset is complete or purchased, the company must then pay the bank rent expense from the cash flows of that asset or project. Overtime, the islamic bond is paid off in rent using fixed payments over a certain amount of time. Then the par value of the the islamic bond is purchased at a future date.

Sukuk Example

For example, Osman is looking to start a new production line in his business that will require the equivalent of $1 million dollars. Because Osman is building this line in Saudi Arabia, he plans on financing the costs using this islamic bond. He then goes and obtains the financing he needs from an islamic bank. The bank invests in the project. They decide that Osman will owe the bank rent of $80,000 per year and the final par value of the Sukuk, ($1 million) 10 years after the project is done. Notice that this is the same set up as a regular bond where the rent expense of $80,000 is equal to an 8% interest rate. And the par value of the bond is due at the end of the term like a bond.

sukuk

See Also:
Coupon Rate Bond
Interest Rate
What is a Bond?
Nominal Interest Rate
Outstanding Debt

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Time Interest Earned Ratio Analysis

See Also:
EBITDA Definition
Debt Ratio
Financial Ratios
Fixed Charge Coverage Ratio
Debt to Equity Ratio
Long Term Debt to Total Asset Ratio Analysis
Current Ratio Definition

Time Interest Earned Ratio Analysis Definition

Time interest earned ratio (TIE), also known as interest coverage ratio, indicates how well a company can cover its interest payments on a pretax basis. The larger the time interest earned, the more capable the company is at paying the interest on its debt.

Time Interest Earned Ratio Formula

Use the following formula to calculate Time Interest Earned Ratio:

Times Interest Earned Ratio = EBIT / Total Interest

Time Interest Earned Ratio Calculation

EBIT: earnings before interest and taxes. For example, a company has $10,000 in EBIT, and $1,000 in interest payments. As a result, calculate times interest earned ratio as 10,000 / 1,000 = 10

This means that a company has earned ten times its interest charges.

Times Interest Earned Ratio Analysis

Times interest earned ratio measures a company’s ability to continue to service its debt. It is an indicator to tell if a company is running into financial trouble. A high ratio means that a company is able to meet its interest obligations because earnings are significantly greater than annual interest obligations. However, a high ratio can also mean that a company has an undesirably low level of leverage or pays down too much debt with earnings that could be used for other investment opportunities to get higher rate of return.

A lower times interest earned ratio means fewer earnings are available to meet interest payments. Failing to meet these obligations could force a company into bankruptcy. It is used by both lenders and borrowers in determining a company’s debt capacity.

Times Interest Earned Benchmarking Resources

For statistical information about industry financial ratios, please click the following website: www.bizstats.com and www.valueline.com.

time interest earned ratio analysis

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Market Rate

Market Rate Definition

The market rate, defined as the rate of interest, on a loan or investment, which is commonly available on the market for that product, defined the cost of benefit of the tool. For a loan, the market rate is the average rate of interest that will be charged to the receiver from a variety of providers. To the investor, the market rate is the average rate of interest gained from all or a certain set of investment vehicles which are available on the open market. These create the market rate of interest definition as a whole.

Market Rate Explanation

Market rate, explained as the rate to expect when seeking out an interest bearing tool, is the estimated average of all of the vehicles available. This, as listed above, can be applied to both loan and investment instruments. The market rate of return definition should be understood before the search begins.

Better than or worse than market rates are available. These, however, are the statistical anomaly. Market rate is what should be expected. When a party finds a more favorable rate it should first check other factors. If these do not decrease the benefit of use, the tool with the more favorable rate should be used. This requires market rate analysis to check the validity of each deal.

Market Rate Example

For example, Dwight will soon be receiving 2 market rates: the market rate on a loan for his business and the market rate for his investments. Dwight pays close attention to the market rate of return because he can create an expectation of both cost and benefit from it. He thinks his actions through.

First, Dwight looks for the market rate of loans. Soon after this research, Dwight finds a lender who is asking for less than the market rate. His research has paid off and he takes the loan.

Next, Dwight looks at the market rate vs coupon rate for a bond he may purchase. In this comparison, he evaluates the market rate of return on stock he may purchase. Deciding that more stock is too risky, Dwight relies on his research and opts to buy the bond. He appreciates diversification over the highest interest rate.

Dwight also looks at the market rate of return cash balance he has gained from employee benefits he used to receive. He is happy to receive that he is running average. This tool will be useful for his retirement planning.

Dwight relies on his research. Rather than assuming, he lets the market and his sense of judgement decide for him. Dwight has been a success so far and it seems he will continue to be one.

Market Rate definition

See Also:
Delivery Order
Financing Lease
Lower of Cost or Market (LCM)
Excess Insurance Wiki

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Individual Retirement Account (IRA)

See Also:
Pension Plans
401k
Keogh Plan
Payroll Accounting
Deferred Income Tax

Individual Retirement Account (IRA) Definition

An individual retirement account or IRA is a personal account that an employee of a company can set up. The contributions to the account are tax deferrable until the funds are withdrawn after age 59 1/2. There are also several contribution limits which are set at $5000 per year.

Individual Retirement Account (IRA) Explained

An IRA is a great way for employees to invest a percentage of their paychecks every year so that they will have plenty when they decide to retire. Some IRA advantages are that the contributions are tax free or tax deferred. This means that the account holder will not have to pay taxes until they withdraw the funds after 59 1/2. However, if they take it out sooner than this age then there is a penalty fee. The great advantage of tax deferred contributions is that the account can earn more on interest over time than if the funds were first reduced by taxes and then put into an account. Another disadvantage is the contribution limit. This means that the individual can only earn so much over time even if the employee did want to contribute more.

Individual Retirement Account (IRA) Example

Tim is working for Wawadoo Inc. and has decided that he would like to start an IRA account. He sets up the plan through the company and begins to contribute 10% of his paycheck to it. Tim makes $90,000 per year meaning that if allowed he would make contributions of $9,000 (90,000 * .1). However, he is only allowed to contribute $5,000 into his individual retirement account.

Individual Retirement Account

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Interest Rate Definition

See Also:
Effective Rate of Interest Calculation
Interest Expense
What are the 7 Cs of banking
Time Value of Money (TVM)
Interest Rate Risk
LIBOR vs Prime Rate
Federal Funds Rate Definition
Treasury Inflation Protected Securities

Interest Rate Definition

An interest rate signifies a borrowing cost. The interest rate definition is the rate the lender charges the borrower for the use of money. Quote interest rates as annual rates, which represent a percentage of the borrowed principal. Interest rates are used in all types of business and consumer loans, including auto loans, mortgages, credit cards, and any other contract that involves a borrower and a lender. A borrower with good credit – and therefore less risk of default – can borrow money at a lower rate than a borrower with poor credit.

Benchmark Interest Rates

Business and consumer loans, as well as interest rate derivatives (see below), often rely on benchmark interest rates, such as the fed funds rate, the prime rate, Libor, or U.S. Treasury rates. For example, a company may borrow money from a commercial bank at a rate equal to the prime rate plus a specified quoted margin. The quoted margin, or spread between the benchmark rate and the interest rate used in the loan, would depend on the credit standing of the borrower.

Interest Rate Derivatives

Furthermore, interest rates are also frequently used in financial derivatives, such as interest rate futures and interest rate swaps. With financial derivatives, the value of the derivative instrument depends on fluctuations in the underlying interest rate.

Calculate Interest on Loan

Use the following equations to calculate interest on a loan:

Simple Interest = Principal x Interest Rate x Time Periods

Compound Interest = Principal x (((1 + Interest Rate)^Time Periods) – 1)

Interest Payment = Principal x Interest Rate

Principal = Interest Payment / Interest Rate

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Interest rate definition

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Interest Expense Formula

Interest Expense Formula

Interest expense calculations involve 4 parts: Principal, Rate, Time, and Compounding.

Use the following formula to calculate simple interest expense (which excludes compounding):

Interest Expense = Principal X Rate X Time

To calculate the compound interest rate, use the following formula:

Principal X (1+ (R / N))(N X T)

Where:
R = Interest rate
N = Number of times interest is compounded in a year
T = Time in years

Interest Expense Calculation Principal = $50,000 Interest Rate = 7% Time = 3 years

$50,000 X .07 X 3 = $10,500 in interest expense

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Interest Expense Journal Entry

When recording an interest expense journal entry, the interest expense account is debited and the cash account or the interest payable account is credited. This represents money coming out of the cash or interest payable account and going into the interest expense account.

If you have already recorded the interest payment as a liability, then it may show up on the balance sheet as interest payable. If it has not already been recorded as a liability on the balance sheet, then the amount used to pay for the interest expense will come out of the cash account or the prepaid interest account on the balance sheet. Make this journal entry when the interest expense is recognized.

Journal Entry Example

Depending on the circumstances, the journal entry may look like one of the following:

                                 Debit                Credit

Interest Expense                  $1,000
Cash                                          $1,000

Interest Expense                  $1,000
Interest Payable                              $1,000

Interest Expense                  $1,000
Prepaid Interest                              $1,000

Interest Expense Example

Dwayne has started a company which rents party equipment. The equipment in which he rents are too expensive to buy straight up. Dwayne is considering financing some equipment, mainly the additional trucks he needs to move supplies, so that he could provide a high level of service. Dwayne wonders what his interest expenses would be. He looks on the web to find an “interest expense calculator”. Dwayne calculates these results:

Principal: $50,000 Interest: 7% Time: 3 years Compounding: None

So:

$50,000 X .07 X 3 = $10,500 in interest expense

As you calculate the interest expense in your company, learn how to be a highly effective CFO or financial leader. Download the free 7 Habits of Highly Effective CFOs whitepaper.

interest expense formula

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interest expense formula

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