CHAPTER 14 LONG-TERM LIABILITIES: BONDS … Content...CHAPTER 14 Long-Term Liabilities: Bonds and...

1. (1) To pay the face (maturity) amount of the bonds at a specified date. (2) To pay periodic 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.

3. More than face amount. Because comparable bonds provide a market interest rate (11%) that is less than the rate on the bond being issued (12%), the bond will sell at a premium as the market’s means of equalizing the two interest rates.

4. a. Greater than $26,000,000

b. 1. $26,000,0002. 7%3. 9%4. $26,000,000

5. More than the contract rate

6. a. Premium

b. $125,000 Premium

c. Premium on Bonds Payable

7. A loss of $50,000 [($5,000,000 × 0.98) – ($5,000,000 – $150,000)]

8. A mortgage note is an installment note that is secured by a pledge of the borrower’s assets.If the borrower fails to pay the note, the lender has the right to take possession of the pledgedasset and sell it to pay off the debt.

9. A bond is an interest-bearing note that requires periodic interest payments and repayment of the face amount of the bonds at maturity. Bonds consist of two different components: (1) interest payments made periodically over the life of the bond and (2) the face amount that must be repaid at maturity. The periodic payments consist entirely of interest, and the final payment at maturity consists entirely of principal. Installment notes, on the other hand, haveperiodic payments that consist partially of interest and partially of principal. Each paymentreduces the principal on the note so that at maturity the entire amount borrowed will have beenrepaid.

10. a. As a current liability on the balance sheet.

b. As a long-term liability on the balance sheet.

CHAPTER 14LONG-TERM LIABILITIES: BONDS AND NOTES

DISCUSSION QUESTIONS

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CHAPTER 14 Long-Term Liabilities: Bonds and Notes

PE 14–1A

Earnings before bond interest and income tax………… $750,000 $750,000

Deduct interest on bonds…………………………………… 350,000 238,000

Income before income tax………………………………… $400,000 $512,000Deduct income tax…………………………………………… 160,000 204,800

Net income…………………………………………………… $240,000 $307,200Dividends on preferred stock……………………………… 0 180,000

Available for dividends on common stock……………… $240,000 $127,200Shares of common stock outstanding…………………… ÷200,000 ÷120,000

Earnings per share on common stock…………………… $ 1.20 $ 1.06

1$5,000,000 × 7%

2$400,000 × 40%

3$3,400,000 × 7%

4$512,000 × 40%

5($3,600,000 ÷ $20) × $1.00

PE 14–1B

Earnings before bond interest and income tax………… $2,000,000 $2,000,000Deduct interest on bonds…………………………………… 400,000 250,000

Income before income tax………………………………… $1,600,000 $1,750,000Deduct income tax…………………………………………… 640,000 700,000

Net income…………………………………………………… $ 960,000 $1,050,000Dividends on preferred stock……………………………… 0 300,000

Available for dividends on common stock……………… $ 960,000 $ 750,000Shares of common stock outstanding…………………… ÷ 400,000 ÷ 250,000

Earnings per share on common stock…………………… $ 2.40 $ 3.00

1$4,000,000 × 10%

2$1,600,000 × 40%

3$2,500,000 × 10%

4$1,750,000 × 40%

5($3,000,000 ÷ $25) × $2.50

PRACTICE EXERCISES

Plan 1 Plan 2

Plan 1 Plan 2

1

2

3

4

5

1

2

3

4

5



PE 14–2A

a.

Cash 500,000Bonds Payable 500,000

b.

Interest Expense 12,500Cash 12,500

c.

Bonds Payable 500,000Cash 500,000

PE 14–2B

a.

Cash 800,000Bonds Payable 800,000

b.

Interest Expense 16,000Cash 16,000

c.

Bonds Payable 800,000Cash 800,000



PE 14–3A

Cash 1,153,670Discount on Bonds Payable 46,330

Bonds Payable 1,200,000

PE 14–3B

Cash 2,889,599Discount on Bonds Payable 110,401


PE 14–4A

Interest Expense 58,633Discount on Bonds Payable* 4,633Cash 54,000

* $46,330 ÷ 10 semiannual payments

PE 14–4B

Interest Expense 176,040Discount on Bonds Payable* 11,040Cash 165,000


PE 14–5A

Cash 2,170,604Premium on Bonds Payable 170,604Bonds Payable 2,000,000

PE 14–5B

Cash 8,308,869Premium on Bonds Payable 308,869Bonds Payable 8,000,000



PE 14–6A

Interest Expense 62,940Premium on Bonds Payable* 17,060

Cash 80,000


PE 14–6B

Interest Expense 409,113Premium on Bonds Payable* 30,887

Cash 440,000


PE 14–7A

Bonds Payable 1,500,000Loss on Redemption of Bonds 25,100

Discount on Bonds Payable 70,100Cash 1,455,000

PE 14–7B

Bonds Payable 500,000Premium on Bonds Payable 67,000

Gain on Redemption of Bonds 77,000Cash 490,000

PE 14–8A

a. Cash 65,000Notes Payable 65,000

Issued installment notes for cash.

b. Interest Expense 3,900Notes Payable 11,531

Cash 15,431Paid principal and interest on installment notes.



PE 14–8B

a. Cash 45,000Notes Payable 45,000

Issued installment notes for cash.

b. Interest Expense 3,600Notes Payable 6,134

Cash 9,734Paid principal and interest on installment notes.

PE 14–9A

a. Number of times interest charges earned:

$3,200,000 + $320,000$320,000

$3,600,000 + $300,000$300,000

b. The number of times interest charges are earned has decreased from 13.0 in 2015to 11.0 in 2016. Although the company has adequate earnings to pay interest, thedecline in this ratio may cause concern among debtholders.

PE 14–9B


$5,544,000 + $440,000$440,000

$4,400,000 + $400,000$400,000

b. The number of times interest charges are earned has increased from 12.0 in 2015 to 13.6 in 2016. The increase in this ratio increases debtholders’ confidence in the company’s ability to make its interest payments.

2016: = 11.0

2015: = 13.0

2016: = 13.6

2015: = 12.0



Ex. 14–1Domanico

Co.

a. Earnings before bond interest and income tax………………………… $10,500,000Bond interest………………………………………………………………… 800,000

Balance………………………………………………………………………… $ 9,700,000Income tax……………………………………………………………………… 3,880,000

Net income…………………………………………………………………… $ 5,820,000Dividends on preferred stock……………………………………………… 5,000,000

Earnings available for common stock…………………………………… $ 820,000

Shares of common stock outstanding…………………………………… ÷ 500,000

Earnings per share on common stock…………………………………… $ 1.64

b. Earnings before bond interest and income tax………………………… $11,800,000

Bond interest………………………………………………………………… 800,000

Balance………………………………………………………………………… $11,000,000

Income tax……………………………………………………………………… 4,400,000

Net income…………………………………………………………………… $ 6,600,000

Dividends on preferred stock……………………………………………… 5,000,000

Earnings available for common stock…………………………………… $ 1,600,000



c. Earnings before bond interest and income tax………………………… $13,000,000

Bond interest………………………………………………………………… 800,000

Balance………………………………………………………………………… $12,200,000

Income tax……………………………………………………………………… 4,880,000

Net income…………………………………………………………………… $ 7,320,000

Dividends on preferred stock……………………………………………… 5,000,000

Earnings available for common stock…………………………………… $ 2,320,000



*

** ($10,000,000 preferred stock ÷ $10 par value) × $5 preferred dividend per share

***

Ex. 14–2

Factors other than earnings per share that should be considered in evaluating financing 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.

EXERCISES

$10,000,000 bonds payable × 8% interest

$10,000,000 common stock ÷ $20 par value

*

**

***

*

**

***

*

**

***



Ex. 14–3

Nike’s major source of financing is common stock. It has relatively little long-term debt compared to stockholders’ equity.

Ex. 14–4

The bonds were selling at a premium. This is indicated by the selling price of 103.00, which is stated as a percentage of the face amount and is more than par (100%). The market rate of interest for similar quality bonds was lower than 7.375%, and this is why the bonds were selling at a premium.

Ex. 14–5

1 Cash 600,000Bonds Payable 600,000

1 Interest Expense 24,000Cash 24,000

31 Interest Expense* 8,000Interest Payable 8,000

* $600,000 × 8% × 2/12

Ex. 14–6

a. 1. Cash 17,138,298Discount on Bonds Payable 1,361,702


2. Interest Expense 1,061,170Discount on Bonds Payable 136,170Cash 925,000

3. Interest Expense 1,061,170Discount on Bonds Payable 136,170

Cash 925,000

May

Nov.

Dec.



Ex. 14–6 (Concluded)

b. Annual interest paid……………………………………………………………… $1,850,000

Plus discount amortized………………………………………………………… 272,340

Interest expense for first year………………………………………………… $2,122,340

c. The bonds sell for less than their face amount because the market rate of interest is greater than the contract rate of interest. Investors are not willing topay the full face amount for bonds that pay a lower contract rate of interest thanthe rate they could earn on similar bonds (market rate).

Ex. 14–7

a. Cash 13,023,576Premium on Bonds Payable 1,023,576Bonds Payable 12,000,000

b. Interest Expense 377,642Premium on Bonds Payable* 102,358

Cash** 480,000

* $1,023,576 ÷ 10 semiannual payments

** $12,000,000 × 8% × 6/12

c. The bonds sell for more than their face amount because the market rate of interest is less than the contract rate of interest. Investors are willing to pay more for bonds that pay a higher rate of interest (contract rate) than the ratethey could earn on similar bonds (market rate).

Ex. 14–8

1 Cash 22,000,000Bonds Payable 22,000,000


1 Bonds Payable 22,000,000Loss on Redemption of Bonds 440,000

Cash* 22,440,000

* $22,000,000 × 1.02

Sept.

Mar.

2020 Mar.

2016



Ex. 14–9

1 Cash 15,000,000Bonds Payable 15,000,000


1 Bonds Payable 15,000,000Gain on Redemption of Bonds 600,000Cash* 14,400,000

* $15,000,000 × 0.96

Ex. 14–10

a. 1. Cash 85,000Notes Payable 85,000

2. Interest Expense* 5,950Notes Payable 9,822

Cash 15,772

* $85,000 × 0.07

b. Notes payable are reported as liabilities on the balance sheet. The portion of the note payable that is due within one year is reported as a current liability. The remaining portion of the note payable that is not due within one year is reported as a long-term liability. For this company, the current and noncurrent portionsof the note payable would be reported as follows:

May

2022 Nov.

2016

Nov.




Current liabilities:

Notes payable*………………………………………………………………………… $10,510

* The principal repayment portion of the next installment payment. See computation below.

Noncurrent liabilities:

Notes payable**……………………………………………………………………… $64,668

** Original note payable………………………………………………………………… $85,000

Less principal repayment from year 1…………………………………………… 9,822

Note payable balance at the end of year 1……………………………………… $75,178

Annual payment on note…………………………………………………………… $15,772

Second year interest payment ($75,178 × 0.07)………………………………… 5,262

Principal repayment portion of next installment………………………………… $10,510

Note payable balance at the end of year 1……………………………………… $75,178

Current portion of note payable (due within one year)………………………… 10,510

Noncurrent portion of note payable……………………………………………… $64,668

Ex. 14–11

1 Cash 175,000Notes Payable 175,000

31 Interest Expense 14,000Notes Payable 29,830

Cash 43,830

31 Interest Expense 6,253Notes Payable* 37,577

Cash 43,830

*$43,830 – $6,253

Jan.

2019

Dec.

Dec.

2016



Ex. 14–12

a.

A B D E

Decrease Dec. 31

January 1 Note in Notes Carrying

Carrying Payment Payable Amount

Amount (Cash Paid) (B – C) (A – D)

Dec. 31, 2016 $147,750 $ 43,620 $10,343 (7% of $147,750) $ 33,277 $114,473

Dec. 31, 2017 114,473 43,620 8,013 (7% of $114,473) 35,607 78,866

Dec. 31, 2018 78,866 43,620 5,521 (7% of $78,866) 38,099 40,767

Dec. 31, 2019 40,767 43,620 2,853 40,767 0$174,480 $26,730 $147,750

* The interest expense in 2019 is rounded to $2,853.

b. 2016 Jan. 1 Cash 147,750

Notes Payable 147,750

Dec. 31 Interest Expense 10,343Notes Payable 33,277

Cash 43,620

2017 Dec. 31 Interest Expense 8,013

Notes Payable 35,607Cash 43,620





c. Interest expense of $10,343 would be reported on the income statement.

Interest Expense

Ending Note Carrying Amount)

(7% of January 1

Amortization of Installment Notes

For the

Year

C

*



Ex. 14–13

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

2. The Hunter Corporation bonds outstanding at the end of the current year should be reported as a current liability on the balance sheet because they mature within one year.

Ex. 14–14


$685,000,000 + $147,000,000$147,000,000

$323,000,000 + $194,000,000$194,000,000

b. The number of times interest charges are earned has increased from 2.7 in theprior year to 5.7 in the current year. Although Southwest Airlines had enoughearnings to pay interest in the preceding year, the improvement in this ratio will be welcomed by the debtholders.

Ex. 14–15


$310,500,000 + $13,500,000$13,500,000

$432,000,000 + $16,000,000$16,000,000

b. The number of times interest charges are earned has decreased from 28.0 in 2015to 24.0 in 2016. Although Loomis has adequate earnings to pay interest, the decline in this ratio may cause concern among debtholders.

Preceding year: = 2.7

Current year: = 5.7

2016: = 24.0

2015: = 28.0



Ex. 14–16


b. The number of times interest charges are earned has decreased from 2.2 in 2015 to 1.7 in 2016. Although the company has enough earnings to pay interest in 2016,the deterioration in this ratio is a cause for concern to debtholders.

Ex. 14–17

a. $1,000,000 × 0.75131 = $751,310

b. Cash on hand today can be invested to earn income. If $751,315 is invested at 10%, it will be worth $1,000,000 at the end of three years.

Ex. 14–18

a. First Year: $200,000 × 0.93458 =Second Year: $200,000 × 0.87344 =Third Year: $200,000 × 0.81630 =Fourth Year: $200,000 × 0.76290 =

Total present value

b. $200,000 × 3.38721 = $677,442*

*$2 difference between a. and b. is due to rounding.

c. Cash on hand today can be invested to earn income. If each of the $200,000 of cashreceipts is invested at 7%, it will be worth $677,444 at the end of four years.

Ex. 14–19

$6,250,000 × 6.46321 = $40,395,063

2016: = 1.7$3,500,000 + $5,000,000

$5,000,000

2015: = 2.2$6,000,000 + $5,000,000

$5,000,000

$677,444

$186,916$174,688$163,260$152,580



Ex. 14–20

No. The present value of your winnings using an interest rate of 12% is $31,047,750($6,250,000 × 4.96764), which is less than the present value of your winnings usingan interest rate of 5% ($40,395,063; see Ex. 14–19). This is because the winnings areaffected by the higher interest rate.

Ex. 14–21

Present value of $1 for 10 semiannualperiods at 4.5% semiannual rate………………………… 0.64393

Face amount of bonds……………………………………… $25,000,000 $16,098,250

Present value of an annuity of $1for 10 periods at 4.5%……………………………………… 7.91272

Semiannual interest payment……………………………… $875,000 6,923,630

Total present value (proceeds)……………………………… $23,021,880

* $25,000,000 × 3.5%

Ex. 14–22

Present value of $1 for 10 semiannualperiods at 4.5% semiannual rate………………………… 0.64393


Present value of an annuity of $1for 10 semiannual periods at 4.5% semiannual rate… 7.91272

Semiannual interest payment……………………………… $2,310,000 18,278,383

Total present value (proceeds)……………………………… $45,323,443

* $42,000,000 × 5.5%

Ex. 14–23

a. 1. CashDiscount on Bonds Payable

Bonds Payable

2. Interest Expense*Discount on Bonds PayableCash**

* $43,495,895 × 4.5%

** $50,000,000 × 3.5%

207,3151,750,000

43,495,8956,504,105

50,000,000

1,957,315

×

×

×

×

*

*




3. Interest Expense* 1,966,644Discount on Bonds PayableCash

* ($43,495,895 + $207,315) × 4.5%

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 20 semiannualperiods at 4.5% semiannual rate…………………… 0.41464

Face amount of bonds………………………………… $50,000,000 $20,732,000

Present value of annuity of $1for 20 semiannual periods at 4.5% semiannual rate………………………………………… 13.00794

Semiannual interest payment………………………… $1,750,000 22,763,895

Total present value (proceeds)………………………… $43,495,895

* $50,000,000 × 3.5%

b. Annual interest paid…………………………………………………………… $ 3,500,000

Plus discount amortized*…………………………………………………… 423,959

Interest expense for first year……………………………………………… $ 3,923,959

* $207,315 + $216,644

c. The bonds sell for less than their face amount because the market rate of interest isgreater than the contract rate of interest. Investors are not willing to pay the full faceamount for bonds that pay a lower contract rate of interest than the rate they could earn on similar bonds (market rate).

Ex. 14–24

a. 1. Cash 23,829,684Premium on Bonds PayableBonds Payable

2. Interest Expense* 834,039Premium on Bonds Payable 155,961

Cash**

* $23,829,684 × 3.5%

** $22,000,000 × 4.5%

3. Interest Expense* 828,580Premium on Bonds Payable 161,420

Cash

* ($23,829,684 – $155,961) × 3.5%

216,6441,750,000

990,000

990,000

1,829,68422,000,000

×

× *




b. Annual interest paid……………………………………………………………… $1,980,000Less premium amortized*……………………………………………………… 317,381

Interest expense for first year………………………………………………… $1,662,619

* $155,961 + $161,420

c. The bonds sell for more than their face amount because the market rate of interestis less than the contract rate of interest. Investors are willing to pay more for bonds that pay a higher rate of interest (contract rate) than the rate they could earn on similar bonds (market rate).

Ex. 14–25

a. Present value of $1 for 10 semiannualperiods at 5% semiannual rate……………………… 0.61391

Face amount of bonds…………………………………… $35,000,000 $21,486,850

Present value of an annuity of $1 for 10semiannual periods at 5% semiannual rate………… 7.72173

Semiannual interest payment…………………………… $2,100,000 16,215,633

Proceeds of bond sale…………………………………………………………… $37,702,483

b. First semiannual interest payment…………………………………………… $ 2,100,000

5% of carrying amount of $37,702,483………………………………………… 1,885,124

Premium amortized……………………………………………………………… $ 214,876

c. Second semiannual interest payment………………………………………… $ 2,100,000

5% of carrying amount of $37,487,607*……………………………………… 1,874,380

Premium amortized……………………………………………………………… $ 225,620

* $37,702,483 – $214,876

d. Annual interest paid……………………………………………………………… $ 4,200,000

Less premium amortized*……………………………………………………… 440,496

Interest expense for first year………………………………………………… $ 3,759,504

* $214,876 + $225,620

×

×



Ex. 14–26

a. Present value of $1 for 10 semiannualperiods at 6.0% semiannual rate………………………… 0.55839


Present value of an annuity of $1 for 10 semiannualperiods at 6.0% semiannual rate………………………… 7.36009


Proceeds of bond sale…………………………………………………………… $71,167,524

* $80,000,000 × 4.5%

b. 6.0% of carrying amount of $71,167,524……………………………………… $ 4,270,051

First semiannual interest payment…………………………………………… 3,600,000

Discount amortized……………………………………………………………… $ 670,051

c. 6.0% of carrying amount of $71,837,575*……………………………………… $ 4,310,255

Second semiannual interest payment………………………………………… 3,600,000

Discount amortized……………………………………………………………… $ 710,255

* $71,167,524 + $670,051

d. Annual interest paid……………………………………………………………… $ 7,200,000

Plus discount amortized*………………………………………………………… 1,380,306

Interest expense for first year…………………………………………………… $ 8,580,306

* $670,051 + $710,255

×

× *



Prob. 14–1A

1. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax……… $2,100,000 $2,100,000 $2,100,000Deduct interest on bonds………………………… 0 0 720,000

Income before income tax……………………… $2,100,000 $2,100,000 $1,380,000Deduct income tax………………………………… 840,000 840,000 552,000

Net income………………………………………… $1,260,000 $1,260,000 $ 828,000Dividends on preferred stock…………………… 0 360,000 180,000

Available for dividends on common stock…… $1,260,000 $ 900,000 $ 648,000Shares of common stock outstanding………… ÷1,800,000 ÷ 900,000 ÷ 450,000

Earnings per share on common stock………… $ 0.70 $ 1.00 $ 1.44


Earnings before interest and income tax……… $1,050,000 $1,050,000 $1,050,000Deduct interest on bonds………………………… 0 0 720,000

Income before income tax……………………… $1,050,000 $1,050,000 $ 330,000Deduct income tax………………………………… 420,000 420,000 132,000

Net income………………………………………… $ 630,000 $ 630,000 $ 198,000Dividends on preferred stock…………………… 0 360,000 180,000

Available for dividends on common stock…… $ 630,000 $ 270,000 $ 18,000Shares of common stock outstanding………… ÷1,800,000 ÷ 900,000 ÷ 450,000


3. The principal advantage of Plan 1 is that it involves only the issuance of commonstock, 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 tocommon shareholders than is Plan 2 or 3 if earnings before interest and income taxis $1,050,000. In this case, it has the largest EPS ($0.35). The principal disadvantage of Plan 1 is that, if earnings before interest and income tax is $2,100,000, it offers the lowest EPS ($0.70) on common stock.

The principal advantage of Plan 3 is that less investment would need to be madeby common shareholders. Also, it offers the largest EPS ($1.44) if earnings before interest and income tax is $2,100,000. 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 before a common dividend can be paid. Finally, Plan 3 provides the lowest EPS ($0.04) if earnings before interest and income tax is $1,050,000.

Plan 2 provides a middle ground in terms of the advantages and disadvantagesdescribed in the preceding paragraphs for Plans 1 and 3.

PROBLEMS



Prob. 14–2A

1. Cash 26,646,292Discount on Bonds Payable 1,853,708

Bonds Payable

2. a. Interest Expense 1,232,685Discount on Bonds Payable*Cash


b. Interest Expense 1,232,685Discount on Bonds Payable*Cash


3.

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 of a similar risk.

5. Present value of $1 for 20 semiannualperiods at 4.5% semiannual rate……………………… 0.41464

Face amount of bonds…………………………………… $28,500,000 $11,817,240

Present value of annuity of $1 for 20semiannual periods at 4.5% semiannual rate……… 13.00794


Proceeds of bond issue………………………………………………………… $26,646,292

28,500,000

$1,232,685

92,6851,140,000

92,6851,140,000

×

×



Prob. 14–3A

1. Cash 66,747,178Premium on Bonds PayableBonds Payable

2. a. Interest Expense 2,600,141Premium on Bonds Payable* 212,359

Cash

* $4,247,178 ÷ 20 seminannual payments

b. Interest Expense 2,600,141Premium on Bonds Payable* 212,359

Cash


3.

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 of a similar risk.

5. Present value of $1 for 20 semiannualperiods at 4.0% semiannual rate………………………… 0.45639

Face amount of bonds………………………………………… $62,500,000 $28,524,375

Present value of annuity of $1for 20 semiannual periods at 4.0% semiannual rate…… 13.59033


Proceeds of bond issue……………………………………………………………$66,747,178

$2,600,141

2,812,500

2,812,500

62,500,0004,247,178

×

×



Prob. 14–4A

1.1 Cash 63,532,267

Discount on Bonds Payable 10,467,733Bonds Payable 74,000,000


31 Interest Expense 3,000Interest Payable 3,000

31 Interest Expense 4,331,693Discount on Bonds Payable 261,693Cash 4,070,000

31 Income Summary 4,334,693Interest Expense 4,334,693


30 Interest Expense 9,000Interest Payable 3,000Notes Payable 28,673

Cash 40,673




30 Bonds Payable 74,000,000Loss on Redemption of Bonds 7,940,961

Discount on Bonds Payable 9,420,961Cash* 72,520,000

* $74,000,000 × 0.98

2016 July

Oct.

Dec.

2017 June

Sept

Dec.

2018 June



Prob. 14–4A (Concluded)


Cash 40,673

2. a. 2016: $4,334,693b. 2017: $8,674,956

3. Initial carrying amount of bonds……………………………………………… $63,532,267Discount amortized on December 31, 2016………………………………… 261,693Discount amortized on June 30, 2017……………………………………… 261,693Discount amortized on December 31, 2017………………………………… 261,693

Carrying amount of bonds, December 31, 2017…………………………… $64,317,346

2018 Sept



Prob. 14–5A

1. 2016 July 1 Cash 26,646,292


2. a.31 Interest Expense* 1,199,083


*$26,646,292 × 4.5%

b.30 Interest Expense* 1,201,742


*($26,646,292 + $59,083) × 4.5%

3.

Prob. 14–6A

1. 2016 July 1 Cash 66,747,178

Premium on Bonds Payable 4,247,178Bonds Payable 62,500,000


Premium on Bonds Payable 142,613Cash 2,812,500

*$66,747,178 × 4.0%



*($66,747,178 – $142,613) × 4.0%

3.

2016 Dec.

2017 June

$2,669,887

2017

$1,199,083

Dec. 2016

June



Prob. 14–1B1. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax……… $10,000,000 $10,000,000 $10,000,000

Deduct interest on bonds………………………… 0 0 3,600,000

Income before income tax………………………… $10,000,000 $10,000,000 $ 6,400,000

Deduct income tax………………………………… 4,000,000 4,000,000 2,560,000

Net income…………………………………………… $ 6,000,000 $ 6,000,000 $ 3,840,000

Dividends on preferred stock…………………… 0 2,000,000 1,000,000

Available for dividends on common stock…… $ 6,000,000 $ 4,000,000 $ 2,840,000

Shares of common stock outstanding………… ÷ 4,000,000 ÷ 2,000,000 ÷ 1,000,000



Earnings before interest and income tax……… $6,000,000 $6,000,000 $6,000,000

Deduct interest on bonds………………………… 0 0 3,600,000

Income before income tax………………………… $6,000,000 $6,000,000 $2,400,000

Deduct income tax………………………………… 2,400,000 2,400,000 960,000

Net income…………………………………………… $3,600,000 $3,600,000 $1,440,000

Dividends on preferred stock…………………… 0 2,000,000 1,000,000

Available for dividends on common stock…… $3,600,000 $1,600,000 $ 440,000

Shares of common stock outstanding………… ÷4,000,000 ÷2,000,000 ÷1,000,000


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 $6,000,000. In this case, it has the largest EPS ($0.90). The principal disadvantage of Plan 1 is that, if earnings before interest and income tax is $10,000,000, it offers the lowest EPS ($1.50) on common stock.

The principal advantage of Plan 3 is that less investment would need to be madeby common shareholders. Also, it offers the largest EPS ($2.84) if earnings beforeinterest and income tax is $10,000,000. 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 before a common dividendcan be paid. Finally, Plan 3 provides the lowest EPS ($0.44) if earnings before interest and income tax is $6,000,000.

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



Prob. 14–2B

1. Cash 42,309,236Discount on Bonds Payable 3,690,764

Bonds Payable

2. a. Interest Expense 2,392,269Discount on Bonds Payable*Cash

*$3,690,764 ÷ 40 semiannual payments

b. Interest Expense 2,392,269Discount on Bonds Payable*Cash

*$3,690,764 ÷ 40 semiannual payments

3.

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 of a similar risk.

5. Present value of $1 for 40 semiannualperiods at 5.5% semiannual rate……………………… 0.11746

Face amount of bonds…………………………………… $46,000,000 $ 5,403,160

Present value of an annuity of $1 for 40semiannual periods at 5.5% semiannual rate……… 16.04612


Proceeds of bond issue………………………………………………………… $42,309,236

$2,392,269

46,000,000

92,269

92,2692,300,000

2,300,000

×

×



Prob. 14–3B

1. Cash 73,100,469Premium on Bonds PayableBonds Payable

2. a. Interest Expense 3,494,977Premium on Bonds Payable* 405,023

Cash

*$8,100,469 ÷ 20 semiannual periods

b. Interest Expense 3,494,977Premium on Bonds Payable* 405,023

Cash

*$8,100,469 ÷ 20 semiannual periods

3.

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

5. Present value of $1 for 20 semiannualperiods at 5% semiannual rate…………………… 0.37689

Face amount of bonds………………………………… $65,000,000 $24,497,850

Present value of an annuity of $1 for 20semiannual periods at 5% semiannual rate……… 12.46221

Semiannual interest payment………………………… $3,900,000 48,602,619

Proceeds of bond issue……………………………………………………… $73,100,469

65,000,0008,100,469

$3,494,977

3,900,000

3,900,000

×

×



Prob. 14–4B

1.1 Cash 62,817,040




31 Interest Expense 2,084,148Premium on Bonds Payable 390,852

Cash 2,475,000



Cash 2,475,000


Cash 97,342



Cash 2,475,000


30 Bonds Payable 55,000,000Premium on Bonds Payable 6,253,632

Gain on Redemption of Bonds 4,603,632Cash* 56,650,000

*$55,000,000 × 1.03

Oct.

2016 July

Dec.

2017 June

Sept.

Dec.

2018 June



Prob. 14–4B (Concluded)


Cash 97,342

2. a. 2016: 2,093,148b. 2017: 4,203,069

3. Initial carrying amount of bonds…………………………………………… $62,817,040Premium amortized on December 31, 2016……………………………… (390,852)Premium amortized on June 30, 2017……………………………………… (390,852)Premium amortized on December 31, 2017……………………………… (390,852)

Carrying amount of bonds, December 31, 2017………………………… $61,644,484

2018 Sept.



Prob. 14–5B

1. 2016 July 1 Cash 42,309,236




*$42,309,236 × 5.5%



*($42,309,236 + $27,008) × 5.5%

3.

Prob. 14–6B

1. 2016 July 1 Cash 73,100,469




*$73,100,469 × 5%



*($73,100,469 – $244,977) × 5%

3.

June

$2,327,008

Dec. 2016

$3,655,023

2017

2016 Dec.

2017 June



CP 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 manager. “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 financing plans prior to selling the $11 billion of bonds, but there was nothing unethical 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.

CP 14–2

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

CASES & PROJECTS



CP 14–3

Receive $100,000,000 today:

Present value of $100,000,000 today = $100,000,000

Receive $25,000,000 today, plus $9,000,000 per year for 8 years:

Present value of $25,000,000 today = $25,000,000

Present value of annual payments = $9,000,000 × 5.97130 (Present value of an annuity of $1 for 8 periods at 7%) = $53,741,700

Total value = Present value of $25,000,000 + Present value of annual payments

Total value = $25,000,000 + $53,741,700 = $78,741,700

Receive $15,000,000 per year for 10 years:

Present value of annual payments = $15,000,000 × 7.02358 (Present value of an annuity of $1 for 10 periods at 7%) = $105,353,700

The option that has the highest value in terms of present value is to receive $15,000,000 a year for 10 years.

CP 14–4

The primary advantage of issuing preferred stock rather than bonds is that the preferred stock does not obligate Xentec to pay dividends, while interest on bonds must be paid. The issuance of bonds will require annual interest payments,necessitating a periodic (probably semiannual) cash outflow. Given SweepingBluff Golf Course’s volatility of operating cash flows, the required interest payments might strain Xentec’s liquidity. In the extreme, this could even lead to a bankruptcy of Xentec.

The issuance of bonds has the advantage of providing a tax deduction for interest expense. This would tend to reduce the net (after-tax) cost of the bonds. Probably the safest alternative is for Xentec to issue preferred stock. Of course, another alternative might be to issue a combination of preferred stock and bonds.



CP 14–5

1.

Shares of common stock………………………………… 400,000 950,000

Earnings before bond interest and income tax……… $5,000,000 $5,000,000Deduct interest on bonds………………………………… 2,080,000 1,200,000

Income before income tax………………………………… $2,920,000 $3,800,000

Deduct income tax………………………………………… 1,168,000 1,520,000

Net income…………………………………………………… $1,752,000 $2,280,000

Earnings per share on common stock………………… $ 4.38 $ 2.40

* $1,752,000 ÷ 400,000

** $2,280,000 ÷ 950,000

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 20 years. In case of liquidation, the claims of the bondholders would rank ahead of the claims of the common stockholders.

3. Present stockholders must purchase the new stock if they are to retain their proportionate control and financial interest in the corporation.

b. Because the net income has been relatively stable in the past and anticipated earnings under Plan 1 offer earnings per share of $4.38 for each share of common stock, Plan 1 appears to be somewhat more advantageous for stockholders.

Plan 1 Plan 2

***



CP 14–6

$173,751 + $1,459,141$173,751

$214,824 + $1,356,595$214,824

$237,025 + $1,155,894$237,025

2. The number of times interest charges are earned has increased from Year 1 to Year 3.This was due to the company’s decreasing interest expense and increasing earnings during this period.

Year 1: 5.9 =

Year 2: 7.3 =

Year 3:1. 9.4 =


CHAPTER 14 LONG-TERM LIABILITIES: BONDS … Content...CHAPTER 14 Long-Term Liabilities: Bonds and...

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