DISCUSSION QUESTIONS - James Holmesjamesholmes.weebly.com/uploads/1/6/8/5/1685304/warren_sm... ·...

CHAPTER 14LONG TERM LIABILITIES: BONDS AND NOTES

EYE OPENERS

1. (1) To pay the face (maturity) amount of the bonds at a specified date. (2) To pay peri-odic interest at a specified percentage of the face amount.

2. a. Bonds that may be exchanged for other securities under specified conditions.

b. The issuing corporation reserves the right to redeem the bonds before the maturity date.

c. Bonds issued on the basis of the gen-eral credit of the corporation.

3. Less than face amount. Because compara-ble investments in bonds provide a market interest rate (11%) that is greater than the rate on the bond being purchased (10%), the bond will sell at a discount as the mar-ket’s means of equalizing the two interest rates.

4. a. Greater than $9,000,000b. 1. $9,000,000

2. 7%3. 9%4. $9,000,000

5. Less than the contract rate 6. a. Premium

b. $12,085,373c. Premium on Bonds Payable

7. a. Debit Interest ExpenseCredit Discount on Bonds Payable

b. Debit Premium on Bonds PayableCredit Interest Expense

8. No. A bond discount occurs when the con-tract rate of interest on a bond is lower than the market rate of interest. As a result, buy-ers are not willing to pay full face amount for the bonds. The discount may be viewed as the amount needed to entice investors to ac-cept a contract rate of interest that is below the market rate. The discount is initially recorded on the balance sheet as a deduc-tion from bonds payable.

9. The bond issue that is callable is more risky for investors, because the company may re-deem (call) the bond issue if interest rates fall. In addition, since the bonds may be called at their face amount, they will sell for a lower value than the noncallable bond is-sue.

10. A loss of $30,000 [($1,000,000 0.98) – ($1,000,000 – $50,000)]

11. A mortgage note is an installment note that is secured by a pledge of the borrower’s as-sets. In other words, if the borrower fails to pay the note, the lender has the right to take possession of the pledged asset and sell it to pay off the debt.

12. A bond is an interest-bearing note that re-quires periodic interest payments and re-payment of the face amount of the bonds at maturity. Thus, bonds consist of two dif-ferent components: (1) interest payments made periodically over the life of the bond and (2) the face amount that must be repaid at maturity. Therefore, the periodic pay-ments consist entirely of interest, and the fi-nal payment at maturity consists entirely of principal. Installment notes, on the other hand, have periodic payments that consist partially of interest, and partially of principal. Each payment reduces the principal on the note so that at maturity the entire amount borrowed will have been repaid.

13. a. As a current liabilityb. As a long-term liability

14. As an addition to the related bonds payable15. The phrase “time value of money” means

that an amount of cash to be received today is worth more than the same amount of cash to be received in the future. This is be-cause cash on hand today can be invested to earn income.

16. (b) $10,000 to be received at the end of each of the next two years has the higher present value because cash that is received earlier can be invested to earn income.

743743

PRACTICE EXERCISES

PE 14–1A

Plan 1 Plan 2 Earnings before bond interest and income tax............... $800,000 $800,000Bond interest...................................................................... 200,000 1 100,000 3

Balance................................................................................ $600,000 $700,000Income tax........................................................................... 240,000 2 280,000 4

Net income.......................................................................... $360,000 $420,000Dividends on preferred stock............................................ 0 300,000 Earnings available for common stock.............................. $360,000 $120,000Number of common shares............................................... ÷ 400,000 ÷ 300,000 Earnings per share on common stock............................. $ 0.90 $ 0.40 1$2,000,000 × 10%2$600,000 × 40%3$1,000,000 × 10%4$700,000 × 40%

PE 14–1B

Plan 1 Plan 2 Earnings before bond interest and income tax............... $1,000,000 $1,000,000Bond interest...................................................................... 400,000 1 320,000 3

Balance ............................................................................... $ 600,000 $ 680,000Income tax........................................................................... 240,000 2 272,000 4

Net income.......................................................................... $ 360,000 $ 408,000Dividends on preferred stock............................................ 0 200,000 Earnings available for common stock.............................. $ 360,000 $ 208,000Number of common shares............................................... ÷ 200,000 ÷ 160,000 Earnings per share on common stock............................. $ 1.80 $ 1.30 1$5,000,000 × 8%2$600,000 × 40%3$4,000,000 × 8%4$680,000 × 40%

PE 14–2A

Cash....................................................................................... 942,646Discount on Bonds Payable................................................ 57,354

Bonds Payable................................................................. 1,000,000

PE 14–2B

Cash....................................................................................... 663,128Discount on Bonds Payable................................................ 86,872

Bonds Payable................................................................. 750,000

PE 14–3A

Interest Expense................................................................... 57,868Discount on Bonds Payable........................................... 2,868Cash.................................................................................. 55,000

Paid interest and amortized the bond discount ($57,354 ÷ 20).

PE 14–3B

Interest Expense................................................................... 34,937Discount on Bonds Payable........................................... 8,687Cash.................................................................................. 26,250

Paid interest and amortized the bond discount ($86,872 ÷ 10).

PE 14–4A

Cash....................................................................................... 5,193,030Premium on Bonds Payable........................................... 193,030Bonds Payable................................................................. 5,000,000

PE 14–4B

Cash....................................................................................... 3,146,200Premium on Bonds Payable........................................... 146,200Bonds Payable................................................................. 3,000,000

PE 14–5A

Interest Expense................................................................... 255,697Premium on Bonds Payable................................................. 19,303

Cash.................................................................................. 275,000Paid interest and amortized the bond premium ($193,030 ÷ 10).

PE 14–5B

Interest Expense...................................................................... 165,380Premium on Bonds Payable................................................... 14,620

Cash..................................................................................... 180,000Paid interest and amortized the bond premium ($146,200 ÷ 10).

PE 14–6A

Bonds Payable......................................................................... 500,000Loss on Redemption of Bonds.............................................. 25,000

Discount on Bonds Payable.............................................. 50,000Cash..................................................................................... 475,000

PE 14–6B

Bonds Payable......................................................................... 200,000Premium on Bonds Payable................................................... 15,000

Gain on Redemption of Bonds.......................................... 20,000Cash..................................................................................... 195,000

PE 14–7A

a. Cash................................................................................... 65,000Notes Payable................................................................ 65,000

Issued $65,000 of installment notes for cash.

b. Interest Expense............................................................... 6,500Notes Payable.................................................................... 8,424

Cash............................................................................... 14,924Paid principal and interest on installment notes.

PE 14–7B

a. Cash................................................................................... 35,000Notes Payable................................................................ 35,000

Issued $35,000 of installment notes for cash.

b. Interest Expense............................................................... 4,200Notes Payable.................................................................... 5,509

Cash............................................................................... 9,709Paid principal and interest on installment notes.

EXERCISES

Ex. 14–1

Miller Co.

a. Earnings before bond interest and income tax........... $ 3,000,000Bond interest.................................................................. 1,000,000 Balance............................................................................ $ 2,000,000Income tax....................................................................... 800,000 Net income...................................................................... $ 1,200,000Dividends on preferred stock........................................ 1,000,000 Earnings available for common stock.......................... $ 200,000 Earnings per share on common stock......................... $ 0.50

b. Earnings before bond interest and income tax........... $ 4,000,000Bond interest.................................................................. 1,000,000 Balance............................................................................ $ 3,000,000Income tax....................................................................... 1,200,000 Net income...................................................................... $ 1,800,000Dividends on preferred stock........................................ 1,000,000 Earnings available for common stock.......................... $ 800,000 Earnings per share on common stock......................... $ 2.00

c. Earnings before bond interest and income tax........... $ 5,000,000Bond interest.................................................................. 1,000,000 Balance............................................................................ $ 4,000,000Income tax....................................................................... 1,600,000 Net income...................................................................... $ 2,400,000Dividends on preferred stock........................................ 1,000,000 Earnings available for common stock.......................... $ 1,400,000 Earnings per share on common stock......................... $ 3.50

Ex. 14–2

Factors other than earnings per share that should be considered in evaluating fi-nancing plans include: bonds represent a fixed annual interest requirement, while dividends on stock do not; bonds require the repayment of principal, while stock does not; and common stock represents a voting interest in the ownership of the corporation, while bonds do not.

Ex. 14–3

Nike’s major source of funding is common stock. It has long-term debt, exclud-ing current installments, of $409.5 million, compared to stockholders’ equity of $7,025.4 million.

Ex. 14–4

The bonds were selling at a premium. This is indicated by the selling price of 126.987, which is stated as a percentage of face amount and is more than par (100%). The market rate of interest for similar quality bonds was lower than 8%, and this is why the bonds were selling at a premium.

Ex. 14–5

Apr. 1 Cash...................................................................... 24,000,000Bonds Payable................................................. 24,000,000

Oct. 1 Interest Expense.................................................. 1,200,000Cash.................................................................. 1,200,000

Dec. 31 Interest Expense.................................................. 600,000*Interest Payable............................................... 600,000

Accrue interest.*24,000,000 × 10% × 3/12

Ex. 14–6

a. 1. Cash........................................................................... 44,346,760Discount on Bonds Payable.................................... 5,653,240

Bonds Payable..................................................... 50,000,0002. Interest Expense....................................................... 2,000,000

Cash...................................................................... 2,000,0003. Interest Expense....................................................... 2,000,000

Cash...................................................................... 2,000,0004. Interest Expense....................................................... 1,130,648

Discount on Bonds Payable............................... 1,130,648$5,653,240 ÷ 5 years = $1,130,648.

b. Annual interest paid....................................................... $4,000,000Plus discount amortized................................................ 1,130,648 Interest expense for first year....................................... $5,130,648

Ex. 14–7

a. Cash................................................................................. 25,853,146Premium on Bonds Payable..................................... 1,853,146Bonds Payable.......................................................... 24,000,000

b. Interest Expense............................................................. 1,254,685Premium on Bonds Payable.......................................... 185,315*

Cash........................................................................... 1,440,000** *$1,853,146 ÷ 10 semiannual payments**$24,000,000 × 12% × 6/12

Ex. 14–8

2010Apr. 1 Cash...................................................................... 16,000,000

Bonds Payable................................................. 16,000,000Oct. 1 Interest Expense.................................................. 880,000

Cash.................................................................. 880,0002014Oct. 1 Bonds Payable..................................................... 16,000,000

Loss on Redemption of Bonds.......................... 320,000Cash.................................................................. 16,320,000**$16,000,000 × 1.02

Ex. 14–9

2010Jan. 1 Cash...................................................................... 15,000,000

Bonds Payable................................................. 15,000,000July 1 Interest Expense.................................................. 1,050,000

Cash.................................................................. 1,050,0002016July 1 Bonds Payable..................................................... 15,000,000

Gain on Redemption of Bonds....................... 300,000Cash.................................................................. 14,700,000**$15,000,000 × 0.98

Ex. 14–10

a. 1. Cash........................................................................... 44,000Notes Payable...................................................... 44,000

Issued $44,000 of installment notes for cash.2. Interest Expense....................................................... 2,200

Notes Payable........................................................... 5,404Cash...................................................................... 7,604

Paid principal and interest on installment notes.b. Interest expense, $2,200

Ex. 14–11

2010Jan. 1 Cash...................................................................... 140,000

Notes Payable.................................................. 140,000Issued $140,000 of installment notes for cash.

Dec. 31 Interest Expense.................................................. 15,400Notes Payable...................................................... 8,372

Cash.................................................................. 23,772Paid principal and interest on installment notes.

2019Dec. 31 Interest Expense.................................................. 2,353

Notes Payable...................................................... 21,419Cash.................................................................. 23,772

Paid principal and interest on installment notes.

Ex. 14–12

a.Amortization of Installment Notes

A B C D EDecember Decrease

31January 1 Note in Notes CarryingCarrying Payment Interest Expense (6.5% of January 1 Payable Amount

For the Year Ending: Amount (Cash Paid) Note Carrying Amount) (B – C) (A – D) December 31, 2010 $52,000 $15,179 $3,380 (6.5% of $52,000) $11,799 $40,201December 31, 2011 40,201 15,179 2,613 (6.5% of $40,201) 12,566 27,635December 31, 2012 27,635 15,179 1,796 (6.5% of $27,635) 13,383 14,252December 31, 2013 14,252 15,179 927 (6.5% of $14,252) 14,252 0

$60,716 $8,716 $52,000

Ex. 14–12 Concluded

b.2010Jan. 1 Cash...................................................................... 52,000

Notes Payable.................................................. 52,000Issued $52,000 of installment notes for cash.

Dec. 31 Interest Expense.................................................. 3,380Notes Payable...................................................... 11,799

Cash.................................................................. 15,179Paid principal and interest on installment notes.

2011Dec. 31 Interest Expense.................................................. 2,613


Paid principal and interest on installment notes.2012Dec. 31 Interest Expense.................................................. 1,796


Paid principal and interest on installment notes.2013Dec. 31 Interest Expense.................................................. 927


Paid principal and interest on installment notes.

Ex. 14–13

1. The significant loss on redemption of the series X bonds should be reported in the Other Income and Expense section of the income statement, rather than as an extraordinary loss.

2. The series Y bonds outstanding at the end of the current year should be re-ported as a current liability on the balance sheet because they mature within one year.

Appendix 1 Ex. 14–14

a. $400,000 ÷ 1.10 = $363,636$363,636 ÷ 1.10 = $330,578$330,578 ÷ 1.10 = $300,525

b. $400,000 × 0.75132 = $300,528**There is a slight difference between parts (a) and (b) due to rounding.


a. First Year: $100,000 × 0.94340 = $ 94,340Second Year: $100,000 × 0.89000 = 89,000Third Year: $100,000 × 0.83962 = 83,962Fourth Year: $100,000 × 0.79209 = 79,209

Total present value $346,511

b. $100,000 × 3.46511 = $346,511


$3,000,000 × 7.02358 = $21,070,740


No. The present value of your winnings using an interest rate of 14% is $15,648,360 ($3,000,000 × 5.21612), which is more than one-half of the present value of your winnings using an interest rate of 7% ($21,070,740; see Appendix 1 Ex. 14–16). This is because of the effect of compounding the interest. That is, compound interest functions are not linear functions, but use exponents.


Present value of $1 for 10 (semiannual)periods at 6% (semiannual rate).......................... 0.55840

Face amount of bonds............................................... × $10,000,000 $5,584,000Present value of an annuity of $1

for 10 periods at 6%.............................................. 7.36009Semiannual interest payment................................... × $500,000 3,680,045 Total present value (proceeds)................................. $9,264,045


Present value of $1 for 10 (semiannual)periods at 5% (semiannual rate).......................... 0.61391

Face amount of bonds............................................... × $60,000,000 $36,834,600Present value of an annuity of $1

for 10 periods at 5%.............................................. 7.72174Semiannual interest payment................................... × $4,200,000 32,431,308 Total present value (proceeds)................................. $ 69,265,908


a. 1. Cash........................................................................... 20,868,138Discount on Bonds Payable.................................... 4,131,862

Bonds Payable..................................................... 25,000,0002. Interest Expense....................................................... 1,356,429*

Discount on Bonds Payable............................... 106,429Cash...................................................................... 1,250,000

*$20,868,138 × 6.5%3. Interest Expense....................................................... 1,363,347*

Discount on Bonds Payable............................... 113,347Cash...................................................................... 1,250,000

*($20,868,138 + $106,429) × 6.5%Note: The following data in support of the proceeds of the bond issue stated in the exercise are presented for the instructor’s information. Students are not required to make the computations.Present value of $1 for 10 (semiannual)

periods at 6.5% (semiannual rate)................... 0.28380Face amount........................................................... × $25,000,000 $ 7,095,000Present value of annuity of $1 for

10 periods at 6.5%............................................. 11.01851Semiannual interest payment............................... × $1,250,000 13,773,138 Total present value of bonds payable.................. $20,868,138

b. Annual interest paid............................................... $ 2,500,000Plus discount amortized........................................ 219,776 Interest expense for first year............................... $ 2,719,776


a. 1. Cash........................................................................... 8,588,850Premium on Bonds Payable............................... 588,850Bonds Payable..................................................... 8,000,000

2. Interest Expense....................................................... 515,331*Premium on Bonds Payable..................................... 44,669

Cash...................................................................... 560,000*$8,588,850 × 6%

3. Interest Expense....................................................... 512,651*Premium on Bonds Payable..................................... 47,349

Cash...................................................................... 560,000*($8,588,850 – $44,669) × 6%

b. Annual interest paid....................................................... $1,120,000Less premium amortized............................................... 92,018 Interest expense for first year....................................... $1,027,982


a. Present value of $1 for 10 (semiannual)periods at 6.5% (semiannual rate)........................... 0.53273Face amount.............................................................. × $15,000,000 $ 7,990,950Present value of annuity of $1 for 10periods at 6.5%.......................................................... 7.18883Semiannual interest payment.................................. × $1,125,000 8,087,434 Proceeds of bond sale.............................................. $16,078,384

b. First semiannual interest payment.......................... $ 1,125,0006.5% of carrying amount of $16,078,384................. 1,045,095 Premium amortized................................................... $ 79,905

c. Second semiannual interest payment.................... $ 1,125,0006.5% of carrying amount of $15,998,479*............... 1,039,901 Premium amortized................................................... $ 85,099 *$16,078,384 – $79,905 = $15,998,479

d. Annual interest paid................................................. $ 2,250,000Less premium amortized.......................................... 165,004 *Interest expense for first year.................................. $ 2,084,996 *$79,905 + $85,099 = $165,004


a. Present value of $1 for 10 (semiannual)periods at 7% (semiannual rate).............................. 0.50835Face amount.............................................................. × $40,000,000 $20,334,000Present value of annuity of $1 for 10 periods at 7%. . 7.02358Semiannual interest payment.................................. × $2,200,000 15,451,876 Proceeds of bond sale.............................................. $35,785,876

b. 7% of carrying amount of $35,785,876.................... $ 2,505,011First semiannual interest payment.......................... 2,200,000 Discount amortized................................................... $ 305,011

c. 7% of carrying amount of $36,090,887*.................. $ 2,526,362Second semiannual interest payment.................... 2,200,000 Discount amortized................................................... $ 326,362 *$35,785,876 + $305,011 = $36,090,887

d. Annual interest paid................................................. $ 4,400,000Plus discount amortized.......................................... 631,373 *Interest expense first year....................................... $ 5,031,373 *$305,011 + $326,362 = $631,373

Ex. 14–24

a. Current year:Number of times interest charges earned: 6.8 =

Preceding year:Number of times interest charges earned: 8.5 =

b. The number of times interest charges earned has declined from 8.5 to 6.8 in the current year. Although Southwest Airlines has adequate earnings to pay interest, the decline in this ratio may cause concern among debtholders.

PROBLEMS

Prob. 14–1A

1. Plan 1 Plan 2 Plan 3 Earnings before interest and income tax...... $2,000,000 $2,000,000 $2,000,000Deduct interest on bonds............................... 0 0 500,000 Income before income tax.............................. $2,000,000 $2,000,000 $1,500,000Deduct income tax........................................... 800,000 800,000 600,000 Net income....................................................... $1,200,000 $1,200,000 $ 900,000Dividends on preferred stock......................... 0 500,000 250,000 Available for dividends on common stock. . . $1,200,000 $ 700,000 $ 650,000Shares of common stock outstanding.......... ÷ 1,000,000 ÷ 500,000 ÷ 250,000 Earnings per share on common stock.......... $ 1.20 $ 1.40 $ 2.60

2. Plan 1 Plan 2 Plan 3 Earnings before interest and income tax...... $ 950,000 $950,000 $950,000Deduct interest on bonds............................... 0 0 500,000 Income before income tax.............................. $ 950,000 $950,000 $450,000Deduct income tax........................................... 380,000 380,000 180,000 Net income....................................................... $ 570,000 $570,000 $270,000Dividends on preferred stock......................... 0 500,000 250,000 Available for dividends on common stock. . . $ 570,000 $ 70,000 $ 20,000Shares of common stock outstanding.......... ÷ 1,000,000 ÷ 500,000 ÷ 250,000 Earnings per share on common stock.......... $ 0.57 $ 0.14 $ 0.08

Prob. 14–1A Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of common stock, which does not require a periodic interest payment or return of principal, and a payment of preferred dividends is not required. It is also more attractive to common shareholders than is Plan 2 or 3 if earnings before interest and income tax is $950,000. In this case, it has the largest EPS ($0.57). The principal disadvantage of Plan 1 is that it requires an additional investment by present common shareholders to retain their current interest in the company. Also, if earnings before interest and income tax is $2,000,000, this plan offers the lowest EPS ($1.20) on common stock.

The principal advantage of Plan 3 is that little additional investment would need to be made by common shareholders for them to retain their current in-terest in the company. Also, it offers the largest EPS ($2.60) if earnings be-fore interest and income tax is $2,000,000. Its principal disadvantage is that the bonds carry a fixed annual interest charge and require the payment of principal. It also requires a dividend payment to preferred stockholders be-fore a common dividend can be paid. Finally, Plan 3 provides the lowest EPS ($0.08) if earnings before interest and income tax is $950,000.

Plan 2 provides a middle ground in terms of the advantages and disadvan-tages described in the preceding paragraphs for Plans 1 and 3.

Prob. 14–2A

1. Cash........................................................................... 30,237,139Discount on Bonds Payable.................................... 1,762,861

Bonds Payable..................................................... 32,000,000

2. a. Interest Expense.................................................. 2,008,143Discount on Bonds Payable($1,762,861 ÷ 20)............................................. 88,143Cash................................................................. 1,920,000

b. Interest Expense.................................................. 2,008,143Discount on Bonds Payable.......................... 88,143Cash................................................................. 1,920,000

3. $2,008,143

4. Yes. Investors will not be willing to pay the face amount of the bonds when the interest payments they will receive from the bonds are less than the amount of interest that they could receive from investing in other bonds.

5. Present value of $1 for 20 (semiannual)periods at 6.5% (semiannual rate)........................... 0.28380Face amount.............................................................. × $32,000,000 $ 9,081,600Present value of annuity of $1 for 20 periods at 6.5% 11.01851Semiannual interest payment.................................. × $1,920,000 21,155,539 Proceeds of bond issue........................................... $ 30,237,139

Prob. 14–3A

1. Cash........................................................................... 3,461,181Premium on Bonds Payable............................... 461,181Bonds Payable..................................................... 3,000,000

2. a. Interest Expense.................................................. 164,627Premium on Bonds Payable ($461,181 ÷ 30)..... 15,373

Cash................................................................. 180,000b. Interest Expense.................................................. 164,627

Premium on Bonds Payable............................... 15,373Cash................................................................. 180,000

3. $164,627

4. Yes. Investors will be willing to pay more than the face amount of the bonds when the interest payments they will receive from the bonds exceed the amount of interest that they could receive from investing in other bonds.

5. Present value of $1 for 30 (semiannual)periods at 5% (semiannual rate).............................. 0.23138Face amount.............................................................. × $3,000,000 $ 694,140Present value of annuity of $1 for 30 periods at 5%. . 15.37245Semiannual interest payment.................................. × $180,000 2,767,041 Proceeds of bond issue........................................... $3,461,181

Prob. 14–4A

1.2010July 1 Cash............................................................... 16,675,184

Discount on Bonds Payable........................ 1,324,816Bonds Payable......................................... 18,000,000

Oct. 1 Cash............................................................... 400,000Notes Payable.......................................... 400,000

Dec. 31 Interest Expense........................................... 7,000Interest Payable....................................... 7,000

31 Interest Expense........................................... 900,000Cash.......................................................... 900,000

31 Interest Expense........................................... 132,482Discount on Bonds Payable................... 132,482

31 Income Summary.......................................... 1,039,482Interest Expense...................................... 1,039,482

2011June 30 Interest Expense........................................... 900,000

Cash.......................................................... 900,000Sept. 30 Interest Expense........................................... 21,000

Interest Payable............................................ 7,000Notes Payable............................................... 28,951

Cash.......................................................... 56,951Dec. 31 Interest Expense........................................... 6,493

Interest Payable....................................... 6,49331 Interest Expense........................................... 900,000

Cash.......................................................... 900,00031 Interest Expense........................................... 264,964

Discount on Bonds Payable................... 264,96431 Income Summary.......................................... 2,092,457

Interest Expense...................................... 2,092,4572012June 30 Bonds Payable.............................................. 18,000,000

Loss on Redemption of Bonds.................... 254,888Discount on Bonds Payable................... 794,888Cash.......................................................... 17,460,000**$18,000,000 × 0.97

Prob. 14–4A Concluded

2012Sept. 30 Interest Expense........................................... 19,480


Cash.......................................................... 56,951

2. a. 2010: $1,039,482b. 2011: $2,092,457

3. Initial carrying amount of bonds................................... $16,675,184Discount amortized on December 31, 2010................. 132,482Discount amortized on December 31, 2011................. 264,964 Carrying amount of bonds, December 31, 2011.......... $ 17,072,630

Appendix 2 Prob. 14–5A

1. 2010July 1 Cash............................................................... 30,237,139


2.a. 2010

Dec. 31 Interest Expense........................................... 1,965,414*Discount on Bonds Payable................... 45,414Cash.......................................................... 1,920,000

*$30,237,139 × 6.5%b. 2011

June 30 Interest Expense........................................... 1,968,366*Discount on Bonds Payable................... 48,366Cash.......................................................... 1,920,000

*($30,237,139 + $45,414) × 6.5%

3. $1,965,414

Appendix 2 Prob. 14–6A

1. 2010July 1 Cash............................................................... 3,461,181

Premium on Bonds Payable................... 461,181Bonds Payable......................................... 3,000,000

2.a. 2010

Dec. 31 Interest Expense........................................... 173,059*Premium on Bonds Payable........................ 6,941

Cash.......................................................... 180,000*$3,461,181 × 5%

b. 2011June 30 Interest Expense........................................... 172,712*

Premium on Bonds Payable........................ 7,288Cash.......................................................... 180,000

*($3,461,181 – $6,941) × 5%

3. $173,059

Prob. 14–1B

1. Plan 1 Plan 2 Plan 3 Earnings before interest and income tax...... $15,000,000 $15,000,000 $15,000,000Deduct interest on bonds............................... 0 0 4,800,000 Income before income tax.............................. $15,000,000 $15,000,000 $10,200,000Deduct income tax........................................... 6,000,000 6,000,000 4,080,000 Net income....................................................... $ 9,000,000 $ 9,000,000 $ 6,120,000Dividends on preferred stock......................... 0 3,000,000 1,000,000 Available for dividends on common stock. . . $ 9,000,000 $ 6,000,000 $ 5,120,000Shares of common stock outstanding.......... ÷ 6,000,000 ÷ 3,000,000 ÷ 1,000,000 Earnings per share on common stock.......... $ 1.50 $ 2.00 $ 5.12

2. Plan 1 Plan 2 Plan 3 Earnings before interest and income tax...... $ 7,000,000 $ 7,000,000 $ 7,000,000Deduct interest on bonds............................... 0 0 4,800,000 Income before income tax.............................. $ 7,000,000 $ 7,000,000 $ 2,200,000Deduct income tax........................................... 2,800,000 2,800,000 880,000 Net income....................................................... $ 4,200,000 $ 4,200,000 $ 1,320,000Dividends on preferred stock......................... 0 3,000,000 1,000,000 Available for dividends on common stock. . . $ 4,200,000 $ 1,200,000 $ 320,000Shares of common stock outstanding.......... ÷ 6,000,000 ÷ 3,000,000 ÷ 1,000,000 Earnings per share on common stock.......... $ 0.70 $ 0.40 $ 0.32

Prob. 14–1B Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of common stock, which does not require a periodic interest payment or return of principal, and a payment of preferred dividends is not required. It is also more attractive to common shareholders than is Plan 2 or 3 if earnings before interest and income tax is $7,000,000. In this case, it has the largest EPS ($0.70). The principal disadvantage of Plan 1 is that it requires an additional investment by present common shareholders to retain their current interest in the company. Also, if earnings before interest and income tax is $15,000,000, this plan offers the lowest EPS ($1.50) on common stock.

The principal advantage of Plan 3 is that little additional investment would need to be made by common shareholders for them to retain their current interest in the company. Also, it offers the largest EPS ($5.12) if earnings before interest and income tax is $15,000,000. Its principal disadvantage is that the bonds carry a fixed annual interest charge and require the payment of principal. It also requires a dividend payment to preferred stockholders be-fore a common dividend can be paid. Finally, Plan 3 provides the lowest EPS ($0.32) if earnings before interest and income tax is $7,000,000.

Plan 2 provides a middle ground in terms of the advantages and disadvan-tages described in the preceding paragraphs for Plans 1 and 3.

Prob. 14–2B

1. Cash........................................................................... 35,465,423Discount on Bonds Payable.................................... 9,534,577

Bonds Payable..................................................... 45,000,000

2. a. Interest Expense.................................................. 2,726,729Discount on Bonds Payable($9,534,577 ÷ 20)............................................. 476,729Cash................................................................. 2,250,000

b. Interest Expense.................................................. 2,726,729Discount on Bonds Payable.......................... 476,729Cash................................................................. 2,250,000

3. $2,726,729

4. Yes. Investors will not be willing to pay the face amount of the bonds when the interest payments they will receive from the bonds are less than the amount of interest that they could receive from investing in other bonds.

5. Present value of $1 for 20 (semiannual)periods at 7% (semiannual rate).............................. 0.25842Face amount.............................................................. × $45,000,000 $11,628,900Present value of annuity of $1 for 20 periods at 7%. . 10.59401Semiannual interest payment.................................. × $2,250,000 23,836,523 Proceeds of bond issue........................................... $35,465,423

Prob. 14–3B

1. Cash........................................................................... 42,390,112Premium on Bonds Payable............................... 2,390,112Bonds Payable..................................................... 40,000,000

2. a. Interest Expense.................................................. 2,280,494Premium on Bonds Payable ($2,390,112 ÷ 20).. 119,506

Cash................................................................. 2,400,000b. Interest Expense.................................................. 2,280,494

Premium on Bonds Payable............................... 119,506Cash................................................................. 2,400,000

3. $2,280,494

4. Yes. Investors will be willing to pay more than the face amount of the bonds when the interest payments they will receive from the bonds exceed the amount of interest that they could receive from investing in other bonds.

5. Present value of $1 for 20 (semiannual)periods at 5.5% (semiannual rate)........................... 0.34273Face amount.............................................................. × $40,000,000 $13,709,200Present value of annuity of $1 for 20 periods at 5.5% 11.95038Semiannual interest payment.................................. × $2,400,000 28,680,912 Proceeds of bond issue........................................... $42,390,112

Prob. 14–4B

1.2010July 1 Cash............................................................... 12,390,085

Premium on Bonds Payable................... 2,390,085Bonds Payable......................................... 10,000,000

Oct. 1 Cash............................................................... 225,000Notes Payable.......................................... 225,000

Dec. 31 Interest Expense........................................... 4,500Interest Payable....................................... 4,500

31 Interest Expense........................................... 750,000Cash.......................................................... 750,000

31 Premium on Bonds Payable........................ 119,504Interest Expense...................................... 119,504

31 Income Summary.......................................... 634,966Interest Expense...................................... 634,966

2011June 30 Interest Expense........................................... 750,000

Cash.......................................................... 750,000Sept. 30 Interest Expense........................................... 13,500


Cash.......................................................... 48,671Dec. 31 Interest Expense........................................... 3,887

Interest Payable....................................... 3,88731 Interest Expense........................................... 750,000

Cash.......................................................... 750,00031 Premium on Bonds Payable........................ 239,008

Interest Expense...................................... 239,00831 Income Summary.......................................... 1,287,379

Interest Expense...................................... 1,287,3792012June 30 Bonds Payable.............................................. 10,000,000

Premium on Bonds Payable........................ 1,912,069Gain on Redemption of Bonds............... 1,762,069Cash ($10,000,000 × 101.5%).................. 10,150,000

Prob. 14–4B Concluded

2012Sept. 30 Interest Expense........................................... 11,659


Cash.......................................................... 48,671

2. a. 2010: $634,996b. 2011: $1,287,379

3. Initial carrying amount of bonds................................... $12,390,085Premium amortized on December 31, 2010................. (119,504)Premium amortized on December 31, 2011................. (239,008 )Carrying amount of bonds, December 31, 2011.......... $12,031,573

Appendix 2 Prob. 14–5B

1. 2010July 1 Cash............................................................... 35,465,423


2.a. 2010

Dec. 31 Interest Expense........................................... 2,482,580*Discount on Bonds Payable................... 232,580Cash.......................................................... 2,250,000

*$35,465,423 × 7%b. 2011

June 30 Interest Expense........................................... 2,498,860*Discount on Bonds Payable................... 248,860Cash.......................................................... 2,250,000

*($35,465,423 + $232,580) × 7%

3. $2,482,580

Appendix 2 Prob. 14–6B

1. 2010July 1 Cash............................................................... 42,390,112

Premium on Bonds Payable................... 2,390,112Bonds Payable......................................... 40,000,000

2.a. 2010

Dec. 31 Interest Expense........................................... 2,331,456*Premium on Bonds Payable........................ 68,544

Cash.......................................................... 2,400,000*$42,390,112 × 5.5%

b. 2011June 30 Interest Expense........................................... 2,327,686*

Premium on Bonds Payable........................ 72,314Cash.......................................................... 2,400,000

*($42,390,112 – $68,544) × 5.5%

3. $2,331,456

SPECIAL ACTIVITIES

Activity 14–1

GE Capital’s action was legal, but caused a great public relations stir at the time. Some quotes:“A lot of people feel like they have been sorely used,” said one bond fund man-ager. “There was nothing illegal about it, but it was nasty.”The fund manager said that GE Capital’s decision to upsize its bond issue to $11 billion from $6 billion midway through the offering ordinarily wouldn’t have upset bondholders.“But then to find out two days later that they had filed a $50 billion shelf?” he said. “People buy GE because it’s like buying Treasuries, not because they want to get jerked around.”GE Capital’s action was probably ethical, even though it caused some stir. In its own defense, it stated:In a statement released late Thursday, GE Capital said “with the $11 billion bond issuance of March 13, GE Capital exhausted its existing debt shelf registration; consequently, on March 20, GE Capital filed a $50 billion shelf registration.”The release said the shelf filing was not an offering and that it would be used in part to roll over $31 billion in maturing long-term debt.In retrospect, GE Capital could have been a little more forthcoming about its fi -nancing plans prior to selling the $11 billion on bonds, but there was nothing un-ethical or illegal about its disclosures.

Source: “GE Capital Timing on $50B Shelf Filing Added to Backlash,” Dow Jones Capital Markets Report, March 22, 2002, Copyright (c) 2002, Dow Jones & Company, Inc.

Activity 14–2

Without the consent of the bondholders, Abdou’s use of the sinking fund cash to temporarily alleviate the shortage of funds would violate the bond indenture con-tract and the trust of the bondholders. It would therefore be unprofessional. In addition, the use of Abdou’s brother-in-law as trustee of the sinking fund is a po-tential conflict of interest that could be considered unprofessional.

Activity 14–3

Receive $10,000,000 today:

Present value of $10,000,000 today = $10,000,000

Receive $2,200,000 today, plus $1,050,000 per year for 15 years:

Present value of $2,200,000 today = $2,200,000Present value of annual payments = $1,050,000 × 6.81086 (Present value of an

annuity of $1 for 15 periods at 12%) = $7,151,403

Total value = Present value of $2,200,000 + Present value of annual paymentsTotal value = $2,200,000 + $7,151,403 = $9,351,403

Receive $1,200,000 per year for 15 years:

Present value of annual payments = $1,200,000 × 6.81086 (Present value of an annuity of $1 for 15 periods at 12%) = $8,173,032

The option that has the highest value in terms of present value is to receive $10,000,000 today.

Activity 14–4

The primary advantage of issuing preferred stock rather than bonds is that the preferred stock does not obligate Beacon to pay dividends, while interest on bonds must be paid. That is, the issuance of bonds will require annual interest payments, thus necessitating a periodic (probably semiannual) cash outflow. Given St. Seniors volatility of operating cash flows, the required interest pay-ments might strain Beacon’s liquidity. In the extreme, this could even lead to a bankruptcy of Beacon.The issuance of bonds has the advantage of providing a tax deduction for inter-est expense. This would tend to reduce the net (after-tax) cost of the bonds. Probably the safest alternative is for Beacon to issue preferred stock. Of course, another alternative might be to issue a combination of preferred stock and bonds.

Activity 14–5

1. Plan 1 Plan 2 Shares of common stock............................................... 200,000 300,000 Earnings before bond interest and income tax........... $1,000,000 $1,000,000Deduct interest on bonds.............................................. 600,000 280,000 Income before income tax............................................. $ 400,000 $ 720,000Deduct income tax......................................................... 160,000 288,000 Net income...................................................................... $ 240,000 $ 432,000 Earnings per share on common stock......................... $ 1.20 * $ 1.44 ** *240,000 ÷ 200,000**432,000 ÷ (200,000 + 100,000)

2. a. Factors to be considered in addition to earnings per share:1. There is a definite legal obligation to pay interest on bonds, but

there is no definite commitment to pay dividends on common stock. Therefore, if net income should drop substantially, bonds would be less desirable than common stock.

2. If the bonds are issued, there is a definite commitment to repay the principal in 10 years. In case of liquidation, the claims of the bond-holders would rank ahead of the claims of the common stockhold-ers.

3. Present stockholders must purchase the new stock if they are to re-tain their proportionate control and financial interest in the corpora-tion.

b. Since the net income has been relatively stable in the past and antici-pated earnings under Plan 2 offer earnings per share of $1.44 for the common stockholder, Plan 2 appears to be somewhat more advanta-geous for stockholders.

Activity 14–6

Note to Instructors: The purpose of this activity is to familiarize students with bond ratings and the importance of bond ratings to the issuer as well as to the investor.

Activity 14–7

1. 2007: 46.61 =

2006: 26.98 =

2005: 5.16 =

2. The company’s times interest earned ratio has increased significantly from 2005 to 2007. This was due to the company’s strong earnings during this pe-riod, which was used to pay down the company’s debt, reducing its interest expense and increasing its times interest earned ratio.

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