Chapter 14 Long-Term Liabilities: Bonds and Notes Study ...

Chapter 14 Long-Term Liabilities: Bonds and Notes Study Guide Solutions

Fill-in-the-Blank Equations

1. A discount 2. Face amount 3. A premium 4. Interest expense

Exercises

1. The Garden Supply has two options in financing: issue $3,000,000 of common stock with a $20 par value and $2,000,000 of 10% bonds or issue $2,500,000 of the same common stock and $2,500,000 of the same bonds. All bonds and stock are issued at their par or face amount. If the earnings before interest and income taxes are $750,000 with a 40% tax rate, what would the effect of the two financing options be on the earnings per share?

Common stock, $20 par 10% bonds Total Earnings before interest & income tax Deduct interest on bonds

Income before income tax Deduct income tax

Net income Shares of common stock outstanding Earnings per share on common stock

Option 1 $3,000,000 2,000,000 $5,000,000 750,000 200,000 550,000 220,000 330,000 150,000 $2.20

Option 2 $2,500,000 2,500,000 $5,000,000 750,000 250,000 500,000 200,000 300,000 125,000 $2.40

1

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2 Chapter 14

2. Gifts For All has the financing options below. Assume all bonds and stock are issued at their par or face amount. The company's earnings before interest and income taxes are $1,900,000 with a 35% tax rate. What would the effect of the financing options be on the earnings per share? Round EPS to two decimal places.

Issue 15% bonds Issue preferred 6% stock, $25 par value Issue common stock, $15 par value

Option 1 Amount Percent

--

Option 2 Amount Percent $ 5,000,000 50%

Option 3

Amount Percent

$ 2,500,000

25%

--

2,500,000 25% 2,500,000

25%

$10,000,000 $10,000,000

100% 2,500,000 100% $10,000,000

25% 5,000,000 100% $10,000,000

50% 100%

15% bonds Common stock, $15 par Preferred 6% stock, $25 par Total Earnings before interest & income tax Deduct interest on bonds

Income before income tax Deduct income tax

Net income Dividends on preferred stock Available for dividends on common stock Shares of common stock outstanding Earnings per share on common stock

Option 1 --

$10,000,000 --

$10,000,000 1,900,000 -- 1,900,000 665,000 1,235,000 -- 1,235,000 666,667 $1.85

Option 2 $5,000,000

2,500,000 2,500,000 $10,000,000 1,900,000

750,000 1,150,000

402,500 747,500 150,000 597,500 166,667

$3.58

Option 3 $2,500,000

5,000,000 2,500,000 $10,000,000 1,900,000

375,000 1,525,000

533,750 991,250 150,000 841,250 333,333

$2.52

Option 2 would give the company the highest earnings per share. The option gives the highest tax savings for interest. Although Option 2 generates the lowest net income, less shares of common stock are outstanding to distribute the earnings.

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Long-Term Liabilities: Bonds and Notes 3

3. AMC Corporation has the financing options below. Assume all bonds and stock are issued at their par or face amount. The company's earnings before interest and income taxes for the year are $1,500,000 at a 40% tax rate. Which option would generate the highest earnings per share?

Issue 18% bonds Issue preferred 4% stock, $15 par value Issue common stock, $5 par value

Option 1 Amount Percent

1,000,000 20%

2,500,000 50%

$1,500,000 $5,000,000

30% 100%

Option 2 Amount Percent $3,000,000 60%

Option 3

Amount Percent

$2,000,000

40%

1,000,000 20% 1,500,000

30%

1,000,000 $5,000,000

20% 1,500,000 100% $5,000,000

30% 100%

18% bonds Preferred 4% stock, $15 par Common stock, $5 par Total Earnings before interest & income tax Deduct interest on bonds

Income before income tax Deduct income tax

Net income Dividends on preferred stock Available for dividends on common stock Shares of common stock outstanding Earnings per share on common stock

Option 1 $1,000,000

2,500,000 1,500,000 $5,000,000 1,500,000

180,000 1,320,000

528,000 792,000 100,000 692,000 300,000

$2.31

Option 2 $3,000,000

1,000,000 1,000,000 $5,000,000 1,500,000

540,000 960,000 384,000 576,000

40,000 536,000 200,000

$2.68

Option 3 $2,000,000

1,500,000 1,500,000 $5,000,000 1,500,000

360,000 1,140,000

456,000 684,000

60,000 624,000 300,000

$2.08

Option 2 would give the highest earnings per share.

Strategy: Earnings per share on common stock should be calculated using earnings after interest and income taxes. First, determine the amount of interest to be paid on any bonds outstanding and subtract this amount from earnings before interest and taxes. Subtract income tax from the income before tax to arrive at net income. If any preferred stock is outstanding, dividends will be first be paid to the preferred shareholders, so subtract the preferred dividends from net income to calculate net income allocable to common shareholders. Divide the net income allocable to common shareholders by the common stock outstanding to arrive at earnings per share on common stock.

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4 Chapter 14

4. Roses Corporation issued a bond with a contract interest rate of 10%. The current market rate of a bond is 9%. Is the bond being issued at a discount, premium, or face amount? Would the selling price be higher or lower than the face amount? The bond is being issued at a premium, and the selling price would be higher than the face amount.

5. The Garden Supply issued a $1,000,000 bond for $975,000. Would the contract rate be higher or lower than the market rate? Is the bond being issued at a discount, premium, or face amount? The bond is being issued at a discount, and the contract rate would be lower than the market rate.

6. If The Garden Supply issued a $5,000,000 bond with the same market rate as the contract rate, how much cash would the company receive for the bond? Is the bond being issued at a discount, premium, or face amount? The company would receive $5,000,000 for the bond because it is being issued at face amount. Strategy: A bond issued at face amount means that the contract rate is equal to the market rate, so the amount of cash received is equal to the bond payable. If a premium exists, the contract rate is higher than the market rate, so investors are willing to pay more for the bond. However, if the contract rate is lower than the market rate, investors will only want to invest if they have an incentive, such as a discount.

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Long-Term Liabilities: Bonds and Notes 5

7. The Howling Moon issued $2,500,000 of 5-year, 10% bonds at par value on January 1, 2015. Interest is payable semiannually, on June 30 and December 31. Prepare the journal entries related to the following:

a. Issuance of the bonds

Jan. 1 Cash

2,500,000

Bonds Payable

2,500,000

b. Interest expense on June 30, 2015

June 30 Interest Expense 125,000

Cash

125,000

Interest expense: $2,500,000 ? 10% ? ? year

c. Retirement of the bonds

Jan. 1 Bonds Payable 2,500,000

Cash

2,500,000

8. Burns' Alley issued $1,000,000 of 10-year, 8% bonds at par value on June 30, 2015. The interest is payable annually, beginning on January 1 of the following year. Prepare the journal entries related to the following:

a. Issuance of the bonds

June 30 Cash

1,000,000

Bonds Payable

1,000,000

b. Interest expense on January 1, 2016

Jan. 1 Interest Expense 80,000

Cash

80,000

Interest expense: $1,000,000 ? 8%

c. Retirement of the bonds

June 30 Bonds Payable 1,000,000

Cash

1,000,000

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