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Chapter 9: Problem 35

Use the balance sheet equation to analyze the effects of issuing the following Iong-term bonds. Assume a market interest rate of \(8 \%\) and semiannual compounding. Set up separate columns as necessary. Use a separate cash column. a. \(10,000,000\) bonds for one year at a coupon interest rate of \(10 \%\) b. \(20,000,000\) bonds for three years at a coupon interest rate of \(12 \%\) c. \(5,000,000\) bonds for 10 years at a coupon interest rate of \(10 \%\) d. Discuss why each of these bonds was issued at a premium or discount.

Short Answer

Expert verified
All the stated bonds shall be issued at a premium because their coupon rates are higher than the current market interest rate. Higher coupon rates make bonds more attractive to investors who are willing to pay more for them, resulting in the bonds being issued at a premium.

Step by step solution

01

Bonds Issued at \(10 \%\) Interest Rate

Analyze the first part of the problem which is a bond issued at a \(10 \%\) coupon rate with a face value of \(10,000,000\). First, we need to identify if this bond would be issued at a premium or a discount. Since the market rate is lower than the coupon rate (\(8 \% < 10 \% \)), this bond will be issued at a premium. The issue price of bond will be more than the face value.
02

Bonds Issued at \(12 \%\) Interest Rate

Now move on to the bond issued at a \(12 \% \) coupon rate with a face value of \(20,000,000\). The coupon rate is greater than the market rate (\(12 \% > 8 \% \)). Therefore, this bond will also be issued at a premium. The issue price of this bond will be higher than the face value.
03

Bonds Issued at \(10 \%\) Interest Rate

Lastly, for the bond issued at a \(10 \%\) coupon rate with a face value of \(5,000,000\). The coupon rate is greater than the market rate (\(10 \% > 8 \% \)). Therefore, this bond will also be issued at a premium. The issue price of this bond will be higher than the face value.
04

Discussion

The reasons for each of these bonds being issued at a premium is simply that the coupon rates in all cases are greater than the market rate. Premium bonds are more attractive to investors because the coupon rate is higher than the market rate which means that they can anticipate higher returns on those bonds.

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Key Concepts

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

Long-Term Bonds
Long-term bonds are a critical financial tool used by companies and governments to raise funds. These bonds have a maturity date extending over a term longer than five years. When a company issues a long-term bond, it promises to pay the bondholder a series of interest payments over the life of the bond. The maturity date is when the issuer will repay the bond's face value to the bondholder.
When dealing with long-term bonds, several factors come into play:
  • Maturity Period: This is the time frame over which the bond investment takes place. Longer-maturing bonds often offer higher yields to compensate for the increased risk.
  • Interest Payments: Also known as coupon payments, these are typically made semiannually and fixed at the time of issuance.
Understanding these characteristics helps investors make informed decisions about the risks and benefits of purchasing a certain long-term bond.
Coupon Rate
The coupon rate of a bond is the annual interest rate paid by the bond's issuer to the bondholder. It is expressed as a percentage of the face value of the bond. This rate is crucial because it determines the regular income investors will receive from holding the bond.
There are several considerations related to coupon rates:
  • Fixed Income: The coupon rate provides bondholders with a predictable income stream over the bond's maturity.
  • Market Variability: A bond's coupon rate does not change with market interest rates, meaning it can become more or less attractive depending on market conditions.
In essence, the coupon rate is an important feature distinguishing bonds as a fixed-income investment option.
Market Interest Rate
The market interest rate is the rate of return expected by investors from other comparable investments in the financial market. It influences how a bond is priced and perceived in the market.
Key points about market interest rate include:
  • Interest Rate Fluctuations: When market rates go up, existing bonds with lower coupon rates may sell at a discount since newer issues offer higher returns.
  • Influence on Premium or Discount: A bond's coupon rate compared to the market interest rate determines if it will sell at a premium or discount.
Thus, understanding market interest rates helps investors assess the relative value of bonds and their potential profitability.
Premium and Discount Bonds
Premium and discount bonds are terms used to describe how bonds are priced in comparison to their face value. These classifications arise when the bond's coupon rate is different from the prevailing market interest rates.
Here's how they work:
  • Premium Bonds: These are sold at a price higher than their face value because their coupon rate is higher than the market interest rate. This means investors are willing to pay more upfront for higher coupon payments.
  • Discount Bonds: Conversely, when a bond is sold for less than its face value, it's considered a discount bond. This occurs when the market rate exceeds the bond's coupon rate.
Understanding why bonds sell at premiums or discounts is critical to evaluating the potential returns and risks associated with bond investments.

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Most popular questions from this chapter

During \(2000,\) Wilbur Mills, Inc., recognized an additional \(12\) million of depreciation expense on its income statement and reported \(16\) million as depreciation on its tax return. During 2000 , the statutory income tax rate was reduced from 40 to \(35 \%\), effective at the beginning of \(2000 .\) Pre-tax income was \(\$ 14\) million. Determine the following amounts for 2000 a. Income tax expense. b. Income tax payable. c. Difference between the book and tax bases of Wilbur Mills'assets at year- end. d. Deferred tax liability at year-end. e. Percentage relationship between pre-tax income and income tax expense reported in the income statement.

Sally Shrimpton's pottery business was quite successful and needed to expand further. However, she wanted to avoid paying periodic interest payments to the bank. She saw an ad for discounted notes and decided they were preferable, compared to an interest-bearing note. Show the effects of each of the following transactions on the balance sheet equation. Set up separate columns as necessary and use a separate cash column. 1\. Sally signed a discounted, three-year, \(200,000\) note (see Chapter 8 ) and received the proceeds. When she got home and read the fine print on the note, she found that the note doesn't require periodic interest payments as intended. She also found, however, that the note includes a \(12 \%\) interest rate. She was convinced that the bank made a mistake. On her next bank statement, she was surprised and shocked that her account didn't show a deposit of \(200,000\) into her account on the day she signed the note; in fact, the deposit was much less. Calculate the loan proceeds and determine the effects of the loan on the firm's balance sheet equation. 2\. Because Sally now understands that interest is included in all notes, whether she makes any periodic interest payments, record interest expense for the first year. 3\. Record interest expense for each of the next two years. 4\. Record the final payment on the note. 5\. What payment would Sally have been required to make if she had repaid the note at the end of the second year? Why wouldn't she pay the entire \( 200,000\) if she repaid the note at the end of the second year?

Hansel, Inc., is an international company specializing in debt collection with a range of complementary credit management services. It is headquartered in \(\mathrm{Am}\) sterdam and aims to maintain and enhance its position as Europe's leading force in debt collection. Its 1999 financial statements list bank loans of \(拢 17,000,000\) \((拢=\) pounds sterling ) with the following related note: BANK LOANS The company has entered into a syndicated loan facility of \(拢 25,400,000\) of which \( 20,000,000\) has been used as of December 31,1999 (December 31 \(1998: \& 13,000,000) . \& 17,000,000\) has been classified as long-term (1998 813,000,000 ). The facility expires on December \(16,2001 .\) The interest is calculated at \(1.5 \%\) over IIBOR.A fee of \(0.5 \%\) p.a. over the non-utilized part of the facility is payable. There are no additional costs on an early redemption. a. Explain each of the unusual terms or provisions described in this footnote. Note that "IIBOR" is the "Iondon Inter-Bank Offer Rate" and that "p.a." means per annum" or annually. b. Calculate the annual fee on the unused portion of this credit arrangement, assuming the above balances were all outstanding during 1999 c. Assuming no changes in monetary amounts, will these liabilities be shown as a current liability at the end of 2000 ? What must happen for them to remain as a long-term liability? d. What amount must be included as the long-term liability on the balance sheet at the end of \(1999 ?\) Why? e. From the perspective of management, what else would you like to know about these long-term debts that is not shown in the financial statements? f. For an investor evaluating a large international company, are these significant and unusual long-term debts? g. How does the accounting disclosure of these long-term debts compare to the treatment of 30 -year bonds discussed in this chapter?

Identify several reasons why managers may prefer to issue long-term bonds to a number of investors, rather than borrow directly from a few financial institutions.

If a long-term bond is issued at a discount, both the carrying value of the bond and the recognized interest expense will increase in each successive period during which the bond is outstanding. Explain why this occurs.
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