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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