Financial Reporting & Analysis 6th Edition By Lawrence Revsine – Test Bank

Chapter 11 Solutions
Financial Instruments as Liabilities
Exercises

E11-1. Finding the issue price
(AICPA adapted)

We know that the bonds were priced to yield 8% when the contract interest rate was only 6%. Since the yield is higher than the contract interest rate, we know the bonds were sold at a discount, and we must use the yield to maturity to find interest expense and the price of the bond.

Face value $100,000
Years to maturity 10
Stated interest rate 6%
Yield to maturity
8%
Present value of principal
($100,000 at 4% for 20 periods: 4.5639)
$45,639

Interest payments (3% of $100,000)

3,000
Present value of interest payments
(Annuity of $3,000 for 20 periods at 4%:
13.59033)

_40,771
Bond issue (selling) price 7/1/14
(Present value of the bond)
$86,410

E11-2. Determining market price following a change in interest rate

Now we’ve moved one year closer to the maturity date. So, two aspects of the calculation in E11-1 will have changed: The yield to maturity is now 10% (or 5% per period), and there are 18 periods to maturity.

Present value of principal
($100,000 at 5% for 18 periods: .41552)
$41,552
Present value of interest payments
(Annuity of $3,000 for 18 periods at 5%: 11.68959)

_35,069
Bond market price 7/1/15
(Present value of the bond)
$76,621

E11-3. Finding the discount at Issuance

To find the amount of amortization on July 1, 2014 we first need to know the book value of the bond on that date. Since this is the first interest payment date, the beginning-of-period book value is the same as the original issue (selling) price, which is the face value less any discount (or plus any premium). With this knowledge, we can find the interest payable and the interest expense using the effective and stated interest rates respectively, as is done below.

Market Rate 14%
Contractual Rate, payable semiannually 12%
Face Value
$500,000
Discount
($52,970)
Issue Price of Bond on January 1, 2014 $447,030

Semiannual:
7/1/14 Interest expense (7% of $447,030)
31,292
7/1/14 Interest payment (6% of $500,000)
30,000
7/1/14 Amortization $ 1,292

Use a calculator or an Excel spreadsheet to determine the $447,030 issue price, and thus the $52,970 discount ($500,000 face minus $447,030 issue price).

E11-4. Determining a bond’s balance sheet value
(AICPA adapted)

Even though the bonds pay interest only annually on December 31, the
June 30 balance sheet would still need to reflect interest accrued since the issue date:

DR Interest expense $23,475
CR Interest payable $22,500
CR Bond discount 975

Interest expense is $23,475 = $469,500 x 10% x 1/2 year, interest payable is $22,500 = $500,000 x 9% x 1/2 year, and the amortization is the difference between these two amounts.

The June 30 book value of the bond is $470,475 or the original issue price of $469,500 plus the $975 discount amortization.

E11-5. Calculating gain or loss at early retirement
(AICPA adapted)

The gain (or loss) on bond extinguishment can be computed as follows:

Reacquisition price ($1,020,000)
Face value 1,000,000
Unamortized premium 78,000
Book value of bonds 5/1/15 1,078,000
Gain on extinguishment of debt $58,000

The reacquisition price is the cash paid out by Davis to reacquire its bonds. Since it is less than the book value of the bonds, the company realizes a gain on the retirement of its debt.

E11-6. Amortizing a premium
(AICPA adapted)

To find the amount of unamortized premium on June 30, 2015, we first need to find the interest expense for 2015 (6% of the June 30, 2014, book value, 6% of $105,000).

Date Interest
Payment Interest Expense Premium Amortization
Book Value
6/30/14 105,000
6/30/15 7,000 6,300 700 104,300

The carrying (or book) value of the bond on June 30, 2015, is $104,300. We know that the face value of the bond is $100,000 and the book value is $104,300; the difference between the face value and book value of the bond must be the unamortized premium. So Webb should report $4,300 of unamortized premium in its June 30, 2015, balance sheet.

E11-7. Recording loss contingencies
(AICPA adapted)

Brower expects to receive $3.2 million as compensation for the expropriation of its manufacturing plant. The plant has a book value of $5.0 million, so the estimated loss is $1.8 million ($5.0 book value – $3.2 million expropriation proceeds). The journal entry to record the intended expropriation is:

DR Estimated loss on expropriation of
foreign plant $1,800,000
CR Allowance for estimated loss on
foreign plant $1,800,000

E11-8. Zero coupon bond

Requirement 1:
These bonds have a face value of $250 million, a zero coupon rate, a market yield rate of 12%, and mature in 20 years. The issue price is:

Present value of principal
($250 million at 12% for 20 periods)
$25,916,691
Present value of interest payment
(Annuity of zero for 20 periods at 12%)

0
Bond issue price 1/1/14
(Present value of the bond)
$25,916,691
Alternatively, using PV tables: $250 million x 10.367 = $25,917,500

If the market interest rate is instead 12% semi-annually (6% each period for 40 periods), then the bond issue price would be $24,305,547.
Alternatively, using PV tables: $250 million x .09722 = $24,305,000

Requirement 2:
How much interest expense would the company record on the bonds in 2014? Although the bonds don’t pay interest, an expense would still be recorded:

Expense = $25,916,691 x 12% = $3,110,003
Alternatively, $25,917,500 x 12% = $3,110,000

Requirement 3:
Interest expense in 2015 would be:

Expense =( $25,916,691 + $3,110,003) x 12% = $3,483,203 rounded
Alternatively, ($25,917,500 + $3,110,100) x 12% = $3,483,312

E11-9. Floating-rate debt

Requirement 1:
The floating interest rate for 2014, set on January 1 of that year, was 12% or the LIBOR rate of 6% plus 6% additional interest. The 2014 interest payment was $24 million ($12 million every 6 months), or the $200 million borrowed multiplied by the 12% floating rate for the year.

For 2015, the floating rate will be 14%, or a LIBOR rate of 8% plus 6% additional interest. So the company will pay out $28 million ($14 million every 6 months) in interest that year, or $200 million borrowed multiplied by the 14% floating rate for the year.

Requirement 2:
The debentures were issued at par for $200 million, so there is no discount or premium to amortize. Interest expense just equals the required cash interest payment: $24 million in 2014 and $28 million in 2015.

E11-10. Identifying incentives for early debt retirement
Requirement 1:
We must first determine the book value of the bonds on December 31, 2014—almost two years after issuance. That would seem easy because the bonds were issued at par, but there is a catch: The interest payment due that day has not yet been paid, so we must bring the books up to date by first recording accrued interest from July 1 through December 31:

DR Interest expense to December 31 $5,000,000
CR Interest payable $5,000,000

$5,000,000 = $125 million x 4%

The total book value (including Interest) of the debt on December 31, 2014, is $130 million, the $125 million borrowed plus the $5 million of interest owed for July 1 through December 31.

The market value of the bonds on December 31, 2014, is: $125 million face value, 8% coupon rate paid semi-annually, 13 years to maturity, and yield of 12%:

Present value of principal
($125 million at 6% for 26 periods)
$27,476,254
Present value of interest payment
(Annuity of $5 million for 26 periods at 6%)
65,015,831

Bond present value 12/31/14
$92,492,085

Plus the accrued interest of $5 million gives a total market value of the bond equal to $97,492,085.

The entry to record the debt extinguishment is:

DR Bonds payable $125,000,000
DR Accrued interest payable 5,000,000
CR Cash $97,492,085
CR Gain on retirement of debt 32,507,915

DR Tax expense (@ 40%) $13,003,166
CR Taxes payable $13,003,166

Requirement 2:
There are several reasons a company might want to retire debt early: take advantage of lower interest rates; postpone scheduled principal repayments; eliminate a conversion feature attached to the debt; improve the company’s mix of debt and equity capital; or earnings management using the “paper” gains from debt retirement. However, unless the company is awash in cash, voluntary retirement is unlikely since the debt would have to be replaced at a higher (12%) interest cost.