DISCUSSION QUESTIONS
Chapter 14
long 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 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.
c. Bonds issued on the basis of the general credit of the corporation.
3. Less than face amount. Because comparable 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 market’s means of equalizing the two interest rates.
4. a. Greater than $9,000,000
b. 1. $9,000,000
2. 7%
3. 9%
4. $9,000,000
5. Less than the contract rate
6. a. Premium
b. $12,085,373
c. Premium on Bonds Payable
7. a. Debit Interest Expense
Credit Discount on Bonds Payable
b. Debit Premium on Bonds Payable
Credit Interest Expense
8. No. A bond discount occurs when the contract rate of interest on a bond is lower than the market rate of interest. As a result, buyers are not willing to pay full face amount for the bonds. The discount may be viewed as the amount needed to entice investors to accept a contract rate of interest that is below the market rate. The discount is initially recorded on the balance sheet as a deduction from bonds payable.
9. The bond issue that is callable is more risky for investors, because the company may redeem (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 issue.
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 assets. 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 requires periodic interest payments and repayment of the face amount of the bonds at maturity. Thus, 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. Therefore, the periodic payments consist entirely of interest, and the final 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 liability
b. As a long-term liability
14. As an addition to the related bonds payable
15. 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 because 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.
PRACTICE EXERCISES
PE 14–1A
Plan 1 Plan 2
Earnings before bond interest and income tax $800,000 $800,000
Bond interest 200,0001 100,0003
Balance $600,000 $700,000
Income tax 240,0002 280,0004
Net income $360,000 $420,000
Dividends on preferred stock 0 300,000
Earnings available for common stock $360,000 $ 120,000
Number 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 $1,000,000
Bond interest 400,0001 320,0003
Balance $ 600,000 $ 680,000
Income tax 240,0002 272,0004
Net income $ 360,000 $ 408,000
Dividends on preferred stock 0 200,000
Earnings available for common stock $ 360,000 $ 208,000
Number 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 942,646
Discount on Bonds Payable 57,354
Bonds Payable 1,000,000
PE 14–2B
Cash 663,128
Discount on Bonds Payable 86,872
Bonds Payable 750,000
PE 14–3A
Interest Expense 57,868
Discount on Bonds Payable 2,868
Cash 55,000
Paid interest and amortized the bond discount
($57,354 ÷ 20).
PE 14–3B
Interest Expense 34,937
Discount on Bonds Payable 8,687
Cash 26,250
Paid interest and amortized the bond discount
($86,872 ÷ 10).
PE 14–4A
Cash 5,193,030
Premium on Bonds Payable 193,030
Bonds Payable 5,000,000
PE 14–4B
Cash 3,146,200
Premium on Bonds Payable 146,200
Bonds Payable 3,000,000
PE 14–5A
Interest Expense 255,697
Premium on Bonds Payable 19,303
Cash 275,000
Paid interest and amortized the bond premium
($193,030 ÷ 10).
PE 14–5B
Interest Expense 165,380
Premium on Bonds Payable 14,620
Cash 180,000
Paid interest and amortized the bond premium
($146,200 ÷ 10).
PE 14–6A
Bonds Payable 500,000
Loss on Redemption of Bonds 25,000
Discount on Bonds Payable 50,000
Cash 475,000
PE 14–6B
Bonds Payable 200,000
Premium on Bonds Payable 15,000
Gain on Redemption of Bonds 20,000
Cash 195,000
PE 14–7A
a. Cash 65,000
Notes Payable 65,000
Issued $65,000 of installment notes for cash.
b. Interest Expense 6,500
Notes Payable 8,424
Cash 14,924
Paid principal and interest on installment notes.
PE 14–7B
a. Cash 35,000
Notes Payable 35,000
Issued $35,000 of installment notes for cash.
b. Interest Expense 4,200
Notes Payable 5,509
Cash 9,709
Paid principal and interest on installment notes.
EXERCISES
Ex. 14–1
Miller
Co.
a. Earnings before bond interest and income tax $ 3,000,000
Bond interest 1,000,000
Balance $ 2,000,000
Income tax 800,000
Net income $ 1,200,000
Dividends 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 $ 4,000,000
Bond interest 1,000,000
Balance $ 3,000,000
Income tax 1,200,000
Net income $ 1,800,000
Dividends 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 $ 5,000,000
Bond interest 1,000,000
Balance $ 4,000,000
Income tax 1,600,000
Net income $ 2,400,000
Dividends 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 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.
Ex. 14–3
Nike’s major source of funding is common stock. It has long-term debt, excluding 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 24,000,000
Bonds Payable 24,000,000
Oct. 1 Interest Expense 1,200,000
Cash 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 44,346,760
Discount on Bonds Payable 5,653,240
Bonds Payable 50,000,000
2. Interest Expense 2,000,000
Cash 2,000,000
3. Interest Expense 2,000,000
Cash 2,000,000
4. Interest Expense 1,130,648
Discount on Bonds Payable 1,130,648
$5,653,240 ÷ 5 years = $1,130,648.
b. Annual interest paid $4,000,000
Plus discount amortized 1,130,648
Interest expense for first year $5,130,648
Ex. 14–7
a. Cash 25,853,146
Premium on Bonds Payable 1,853,146
Bonds Payable 24,000,000
b. Interest Expense 1,254,685
Premium on Bonds Payable 185,315*
Cash 1,440,000**
*$1,853,146 ÷ 10 semiannual payments
**$24,000,000 × 12% × 6/12
Ex. 14–8
2010
Apr. 1 Cash 16,000,000
Bonds Payable 16,000,000
Oct. 1 Interest Expense 880,000
Cash 880,000
2014
Oct. 1 Bonds Payable 16,000,000
Loss on Redemption of Bonds 320,000
Cash 16,320,000*
*$16,000,000 × 1.02
Ex. 14–9
2010
Jan. 1 Cash 15,000,000
Bonds Payable 15,000,000
July 1 Interest Expense 1,050,000
Cash 1,050,000
2016
July 1 Bonds Payable 15,000,000
Gain on Redemption of Bonds 300,000
Cash 14,700,000*
*$15,000,000 × 0.98
Ex. 14–10
a. 1. Cash 44,000
Notes Payable 44,000
Issued $44,000 of installment notes for cash.
2. Interest Expense 2,200
Notes Payable 5,404
Cash 7,604
Paid principal and interest on installment notes.
b. Interest expense, $2,200
Ex. 14–11
2010
Jan. 1 Cash 140,000
Notes Payable 140,000
Issued $140,000 of installment notes for cash.
Dec. 31 Interest Expense 15,400
Notes Payable 8,372
Cash 23,772
Paid principal and interest on installment notes.
2019
Dec. 31 Interest Expense 2,353
Notes Payable 21,419
Cash 23,772
Paid principal and interest on installment notes.
Ex. 14–12
a.
Amortization of Installment Notes
A B C D E
December Decrease 31
January 1 Note in Notes Carrying
Carrying 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 $40,201
December 31, 2011 40,201 15,179 2,613 (6.5% of $40,201) 12,566 27,635
December 31, 2012 27,635 15,179 1,796 (6.5% of $27,635) 13,383 14,252
December 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.
2010
Jan. 1 Cash 52,000
Notes Payable 52,000
Issued $52,000 of installment notes for cash.
Dec. 31 Interest Expense 3,380
Notes Payable 11,799
Cash 15,179
Paid principal and interest on installment notes.
2011
Dec. 31 Interest Expense 2,613
Notes Payable 12,566
Cash 15,179
Paid principal and interest on installment notes.
2012
Dec. 31 Interest Expense 1,796
Notes Payable 13,383
Cash 15,179
Paid principal and interest on installment notes.
2013
Dec. 31 Interest Expense 927
Notes Payable 14,252
Cash 15,179
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 reported 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.
Appendix 1 Ex. 14–15
a. First Year: $100,000 × 0.94340 = $ 94,340
Second Year: $100,000 × 0.89000 = 89,000
Third Year: $100,000 × 0.83962 = 83,962
Fourth Year: $100,000 × 0.79209 = 79,209
Total present value $346,511
b. $100,000 × 3.46511 = $346,511
Appendix 1 Ex. 14–16
$3,000,000 × 7.02358 = $21,070,740
Appendix 1 Ex. 14–17
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.
Appendix 1 Ex. 14–18
Present value of $1 for 10 (semiannual)
periods at 6% (semiannual rate) 0.55840
Face amount of bonds × $10,000,000 $5,584,000
Present value of an annuity of $1
for 10 periods at 6% 7.36009
Semiannual interest payment × $500,000 3,680,045
Total present value (proceeds) $9,264,045
Appendix 1 Ex. 14–19
Present value of $1 for 10 (semiannual)
periods at 5% (semiannual rate) 0.61391
Face amount of bonds × $60,000,000 $ 36,834,600
Present value of an annuity of $1
for 10 periods at 5% 7.72174
Semiannual interest payment × $4,200,000 32,431,308
Total present value (proceeds) $ 69,265,908
Appendix 2 Ex. 14–20
a. 1. Cash 20,868,138
Discount on Bonds Payable 4,131,862
Bonds Payable 25,000,000
2. Interest Expense 1,356,429*
Discount on Bonds Payable 106,429
Cash 1,250,000
*$20,868,138 × 6.5%
3. Interest Expense 1,363,347*
Discount on Bonds Payable 113,347
Cash 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) 0.28380
Face amount × $25,000,000 $ 7,095,000
Present value of annuity of $1 for
10 periods at 6.5% 11.01851
Semiannual interest payment × $1,250,000 13,773,138
Total present value of bonds payable $20,868,138
b. Annual interest paid $ 2,500,000
Plus discount amortized 219,776
Interest expense for first year $ 2,719,776
Appendix 2 Ex. 14–21
a. 1. Cash 8,588,850
Premium on Bonds Payable 588,850
Bonds 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 $1,120,000
Less premium amortized 92,018
Interest expense for first year $1,027,982
Appendix 2 Ex. 14–22
a. Present value of $1 for 10 (semiannual)
periods at 6.5% (semiannual rate) 0.53273
Face amount × $15,000,000 $ 7,990,950
Present value of annuity of $1 for 10
periods at 6.5% 7.18883
Semiannual interest payment × $1,125,000 8,087,434
Proceeds of bond sale $16,078,384
b. First semiannual interest payment $ 1,125,000
6.5% of carrying amount of $16,078,384 1,045,095
Premium amortized $ 79,905
c. Second semiannual interest payment $ 1,125,000
6.5% 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 $ 2,250,000
Less premium amortized 165,004*
Interest expense for first year $ 2,084,996
*$79,905 + $85,099 = $165,004
Appendix 2 Ex. 14–23
a. Present value of $1 for 10 (semiannual)
periods at 7% (semiannual rate) 0.50835
Face amount × $40,000,000 $20,334,000
Present value of annuity of $1 for 10 periods at 7% 7.02358
Semiannual interest payment × $2,200,000 15,451,876
Proceeds of bond sale $35,785,876
b. 7% of carrying amount of $35,785,876 $ 2,505,011
First semiannual interest payment 2,200,000
Discount amortized $ 305,011
c. 7% of carrying amount of $36,090,887* $ 2,526,362
Second semiannual interest payment 2,200,000
Discount amortized $ 326,362
*$35,785,876 + $305,011 = $36,090,887
d. Annual interest paid $ 4,400,000
Plus 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 = [pic]
Preceding year:
Number of times interest charges earned: 8.5 = [pic]
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 $2,000,000
Deduct interest on bonds 0 0 500,000
Income before income tax $2,000,000 $2,000,000 $1,500,000
Deduct income tax 800,000 800,000 600,000
Net income $1,200,000 $1,200,000 $ 900,000
Dividends on preferred stock 0 500,000 250,000
Available for dividends on common stock $1,200,000 $ 700,000 $ 650,000
Shares 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 $950,000
Deduct interest on bonds 0 0 500,000
Income before income tax $ 950,000 $950,000 $450,000
Deduct income tax 380,000 380,000 180,000
Net income $ 570,000 $570,000 $270,000
Dividends on preferred stock 0 500,000 250,000
Available for dividends on common stock $ 570,000 $ 70,000 $ 20,000
Shares 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 interest in the company. Also, it offers the largest EPS ($2.60) if earnings before 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 before 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 disadvantages described in the preceding paragraphs for Plans 1 and 3.
Prob. 14–2A
1. Cash 30,237,139
Discount on Bonds Payable 1,762,861
Bonds Payable 32,000,000
2. a. Interest Expense 2,008,143
Discount on Bonds Payable
($1,762,861 ÷ 20) 88,143
Cash 1,920,000
b. Interest Expense 2,008,143
Discount on Bonds Payable 88,143
Cash 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) 0.28380
Face amount × $32,000,000 $ 9,081,600
Present value of annuity of $1 for 20 periods at 6.5% 11.01851
Semiannual interest payment × $1,920,000 21,155,539
Proceeds of bond issue $ 30,237,139
Prob. 14–3A
1. Cash 3,461,181
Premium on Bonds Payable 461,181
Bonds Payable 3,000,000
2. a. Interest Expense 164,627
Premium on Bonds Payable ($461,181 ÷ 30) 15,373
Cash 180,000
b. Interest Expense 164,627
Premium on Bonds Payable 15,373
Cash 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) 0.23138
Face amount × $3,000,000 $ 694,140
Present value of annuity of $1 for 30 periods at 5% 15.37245
Semiannual interest payment × $180,000 2,767,041
Proceeds of bond issue $3,461,181
Prob. 14–4A
1.
2010
July 1 Cash 16,675,184
Discount on Bonds Payable 1,324,816
Bonds Payable 18,000,000
Oct. 1 Cash 400,000
Notes Payable 400,000
Dec. 31 Interest Expense 7,000
Interest Payable 7,000
31 Interest Expense 900,000
Cash 900,000
31 Interest Expense 132,482
Discount on Bonds Payable 132,482
31 Income Summary 1,039,482
Interest Expense 1,039,482
2011
June 30 Interest Expense 900,000
Cash 900,000
Sept. 30 Interest Expense 21,000
Interest Payable 7,000
Notes Payable 28,951
Cash 56,951
Dec. 31 Interest Expense 6,493
Interest Payable 6,493
31 Interest Expense 900,000
Cash 900,000
31 Interest Expense 264,964
Discount on Bonds Payable 264,964
31 Income Summary 2,092,457
Interest Expense 2,092,457
2012
June 30 Bonds Payable 18,000,000
Loss on Redemption of Bonds 254,888
Discount on Bonds Payable 794,888
Cash 17,460,000*
*$18,000,000 × 0.97
Prob. 14–4A Concluded
2012
Sept. 30 Interest Expense 19,480
Interest Payable 6,493
Notes Payable 30,978
Cash 56,951
2. a. 2010: $1,039,482
b. 2011: $2,092,457
3. Initial carrying amount of bonds $ 16,675,184
Discount amortized on December 31, 2010 132,482
Discount amortized on December 31, 2011 264,964
Carrying amount of bonds, December 31, 2011 $ 17,072,630
Appendix 2 Prob. 14–5A
1. 2010
July 1 Cash 30,237,139
Discount on Bonds Payable 1,762,861
Bonds Payable 32,000,000
2.
a. 2010
Dec. 31 Interest Expense 1,965,414*
Discount on Bonds Payable 45,414
Cash 1,920,000
*$30,237,139 × 6.5%
b. 2011
June 30 Interest Expense 1,968,366*
Discount on Bonds Payable 48,366
Cash 1,920,000
*($30,237,139 + $45,414) × 6.5%
3. $1,965,414
Appendix 2 Prob. 14–6A
1. 2010
July 1 Cash 3,461,181
Premium on Bonds Payable 461,181
Bonds 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. 2011
June 30 Interest Expense 172,712*
Premium on Bonds Payable 7,288
Cash 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 $ 15,000,000
Deduct interest on bonds 0 0 4,800,000
Income before income tax $15,000,000 $15,000,000 $ 10,200,000
Deduct income tax 6,000,000 6,000,000 4,080,000
Net income $ 9,000,000 $ 9,000,000 $ 6,120,000
Dividends on preferred stock 0 3,000,000 1,000,000
Available for dividends on common stock $ 9,000,000 $ 6,000,000 $ 5,120,000
Shares 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 $ 7,000,000
Deduct interest on bonds 0 0 4,800,000
Income before income tax $ 7,000,000 $ 7,000,000 $ 2,200,000
Deduct income tax 2,800,000 2,800,000 880,000
Net income $ 4,200,000 $ 4,200,000 $ 1,320,000
Dividends on preferred stock 0 3,000,000 1,000,000
Available for dividends on common stock $ 4,200,000 $ 1,200,000 $ 320,000
Shares 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 before 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 disadvantages described in the preceding paragraphs for Plans 1 and 3.
Prob. 14–2B
1. Cash 35,465,423
Discount on Bonds Payable 9,534,577
Bonds Payable 45,000,000
2. a. Interest Expense 2,726,729
Discount on Bonds Payable
($9,534,577 ÷ 20) 476,729
Cash 2,250,000
b. Interest Expense 2,726,729
Discount on Bonds Payable 476,729
Cash 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) 0.25842
Face amount × $45,000,000 $11,628,900
Present value of annuity of $1 for 20 periods at 7% 10.59401
Semiannual interest payment × $2,250,000 23,836,523
Proceeds of bond issue $35,465,423
Prob. 14–3B
1. Cash 42,390,112
Premium on Bonds Payable 2,390,112
Bonds Payable 40,000,000
2. a. Interest Expense 2,280,494
Premium on Bonds Payable ($2,390,112 ÷ 20) 119,506
Cash 2,400,000
b. Interest Expense 2,280,494
Premium on Bonds Payable 119,506
Cash 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) 0.34273
Face amount × $40,000,000 $13,709,200
Present value of annuity of $1 for 20 periods at 5.5% 11.95038
Semiannual interest payment × $2,400,000 28,680,912
Proceeds of bond issue $42,390,112
Prob. 14–4B
1.
2010
July 1 Cash 12,390,085
Premium on Bonds Payable 2,390,085
Bonds Payable 10,000,000
Oct. 1 Cash 225,000
Notes Payable 225,000
Dec. 31 Interest Expense 4,500
Interest Payable 4,500
31 Interest Expense 750,000
Cash 750,000
31 Premium on Bonds Payable 119,504
Interest Expense 119,504
31 Income Summary 634,966
Interest Expense 634,966
2011
June 30 Interest Expense 750,000
Cash 750,000
Sept. 30 Interest Expense 13,500
Interest Payable 4,500
Notes Payable 30,671
Cash 48,671
Dec. 31 Interest Expense 3,887
Interest Payable 3,887
31 Interest Expense 750,000
Cash 750,000
31 Premium on Bonds Payable 239,008
Interest Expense 239,008
31 Income Summary 1,287,379
Interest Expense 1,287,379
2012
June 30 Bonds Payable 10,000,000
Premium on Bonds Payable 1,912,069
Gain on Redemption of Bonds 1,762,069
Cash ($10,000,000 × 101.5%) 10,150,000
Prob. 14–4B Concluded
2012
Sept. 30 Interest Expense 11,659
Interest Payable 3,887
Notes Payable 33,125
Cash 48,671
2. a. 2010: $634,996
b. 2011: $1,287,379
3. Initial carrying amount of bonds $12,390,085
Premium 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. 2010
July 1 Cash 35,465,423
Discount on Bonds Payable 9,534,577
Bonds Payable 45,000,000
2.
a. 2010
Dec. 31 Interest Expense 2,482,580*
Discount on Bonds Payable 232,580
Cash 2,250,000
*$35,465,423 × 7%
b. 2011
June 30 Interest Expense 2,498,860*
Discount on Bonds Payable 248,860
Cash 2,250,000
*($35,465,423 + $232,580) × 7%
3. $2,482,580
Appendix 2 Prob. 14–6B
1. 2010
July 1 Cash 42,390,112
Premium on Bonds Payable 2,390,112
Bonds 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. 2011
June 30 Interest Expense 2,327,686*
Premium on Bonds Payable 72,314
Cash 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 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 on 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.
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 contract 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 potential 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 = $2,200,000
Present 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 payments
Total 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 payments 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 interest 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 $1,000,000
Deduct interest on bonds 600,000 280,000
Income before income tax $ 400,000 $ 720,000
Deduct 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 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. Since the net income has been relatively stable in the past and anticipated earnings under Plan 2 offer earnings per share of $1.44 for the common stockholder, Plan 2 appears to be somewhat more advantageous 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 = [pic]
2006: 26.98 = [pic]
2005: 5.16 = [pic]
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 period, 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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