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Chapter 15: Problem 10

McDonald's \(6.375 \%\) bonds due in 2028 were reported as selling for \(108.89 .\) Were the bonds selling at a premium or at a discount? Explain.

Short Answer

Expert verified
The bonds were selling at a premium since the price (108.89) is above the face value (100).

Step by step solution

01

Understanding Bond Pricing

When bonds sell for more than their face value, they are selling at a premium. Conversely, when they sell for less than their face value, they are selling at a discount. Bonds typically have a face value of 100 percent or $100 if the face value is specified in currency.
02

Identify the Selling Price

The exercise states that the bonds are selling for 108.89, which means they are selling for 108.89% of their face value.
03

Determine Premium or Discount

Since the bonds are selling for 108.89%, which is greater than 100%, they are selling for more than their face value. This indicates that the bonds are selling at a premium.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Understanding Premium Bonds
A premium bond is a type of bond that is sold for more than its face value, which is the amount the issuer promises to repay at the bond's maturity. When you see a bond selling for something like 108.89 percent of its face value, as in the McDonald's bond example, this means the bond is being sold at a premium. This happens when the bond's coupon interest rate is higher than the market interest rate. Imagine the bond is like a high-yielding savings account when interest rates in general have dropped. Investors are willing to pay extra because they will receive relatively high interest payments over the bond's life compared to other investments.
  • Anything above 100% is a premium
  • Premium bonds indicate investor demand for a bond's higher interest payouts
When thinking about buying premium bonds, you should consider if the higher cost is worth the extra interest you'll receive.
What Are Discount Bonds?
Discount bonds are those sold below their face value. Think of these as a sale for bonds, where the discounted price makes they a potentially attractive buy. This usually means the bond's coupon rate is lower than the prevailing market interest rates, making other investments with higher yields more appealing. So if another McDonald's bond were selling for, say, 95 percent of its face value, this would be considered a discount. Investors are essentially purchasing a bond for less now, but they will be paid the full face value at maturity.
  • Discount means a selling price below 100%
  • Occurs when market rates exceed the bond's coupon rate
This setup is enticing if you believe that market conditions may improve or simply want a lower upfront expense with a predefined payout at bond maturity.
Exploring the Face Value of Bonds
The face value of a bond is the amount paid to the holder at the bond's maturity, provided there is no default. It is typically set in units like $100 or seen as 100% in bond pricing. Understanding face value is crucial because it's the base line that determines if a bond is a premium or a discount. The face value is the anchor point from which market fluctuations are measured. In our McDonald's example, bonds were selling at 108.89% of their face value, meaning investors pay more because of the premium benefits.
  • Represents the repayment amount at maturity
  • Used to assess premium or discount status
The face value helps ensure comparisons of bond prices are standardized, regardless of face amount set by different issuers.

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Most popular questions from this chapter

Rolfes Corp. produces and sells designer clothing. To finance its operations, Rolfes Corp. issued \(\$ 4,000,000\) of 30 -year, \(7 \%\) callable bonds on January 1,2008 , with interest payable on January 1 and July 1 . The fiscal year of the company is the calendar year. Journalize the entries to record the following selected transactions: 2008 Jan. 1. Issued the bonds for cash at their face amount. July 1. Paid the interest on the bonds. 2014 July 1. Called the bond issue at 96 , the rate provided in the bond indenture. (Omit entry for payment of interest.)

A company purchased a \(\$ 5,000\), 25-year zero-coupon bond for \(\$ 820\) to yield \(8.5 \%\) to maturity. How is the interest revenue computed?

Wolfe Co. produces and distributes fiber optic cable for use by telecommunications companies. Wolfe Co. issued \(\$ 12,000,000\) of 10 -year, \(8 \%\) bonds on May 1 of the current year, with interest payable on May 1 and November 1 . The fiscal year of the company is the calendar year. Journalize the entries to record the following selected transactions for the current year: May 1. Issued the bonds for cash at their face amount. Nov. 1. Paid the interest on the bonds. Dec. 31. Recorded accrued interest for two months.

Nanotech Innovations Co. sells orthopedic supplies to hospitals. Journalize the entries to record the following selected transactions of Nanotech Innovations Co.: a. Purchased for cash \(\$ 600,000\) of Sanhueza Co. \(7 \%\) bonds at 102 plus accrued interest of \(\$ 10,500\). b. Received first semiannual interest. c. At the end of the first year, amortized \(\$ 960\) of the bond premium. d. Sold the bonds at 98 plus accrued interest of \(\$ 3,500\). The bonds were carried at \(\$ 606,720\) at the time of the sale.

Bliss Co., which produces and sells skiing equipment, is financed as follows: \(\begin{array}{lr}\text { Bonds payable, } 6 \% \text { (issued at face amount) } & \$ 4,000,000 \\ \text { Preferred } \$ 2 \text { stock (nonparticipating), \$25 par } & 4,000,000 \\ \text { Common stock, } \$ 20 \text { par } & 4,000,000\end{array}\) Income tax is estimated at \(40 \%\) of income. Determine the earnings per share of common stock, assuming that the income before bond interest and income tax is (a) \(\$ 1,000,000\), (b) \(\$ 1,800,000\), and (c) \(\$ 3,200,000\).
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