91Ó°ÊÓ

Zany Sam's issued \(600,000\) of six-year, \(8 \%\) bonds at a time when the market demanded a yield of \(12 \%\) (on similar bonds). The bonds were issued on January 1 requiring interest payments on each subsequent June 30 and December 31 until maturity. a. Compute the issue price and determine the amount of any premium or discount at the issue date. b. Using the balance sheet equation, show the effects of issuing the bonds on the financial statements. c. Prepare a table showing the amortization of the discount or premium at each of the first four semiannual periods. d. Under normal circumstances, how much cash will be paid at each interest date? e. Determine the carrying value two years after the date of issue. (Reminder: The carrying value or book value of the bonds equals the face amount of the bonds plus the premium, or minus the discount.)

Step by step solution

01

Compute the Issue Price

Bond issue price, if the coupon rate is less than yield, will be at discount. Semiannual coupon payment CP can be calculated as follows: \(600000 * 8% / 2 = \$24000\). The yield per period will be \(12% / 2 = 6% \). So, the bond issue price will be the present value of all future cash flows which can be calculated as follows: \[24000/(1+6%) + 24000/(1+6%)^2 + ... + 24000/(1+6%)^12 + 600000/(1+6%)^12 = \$527368.90\].

02

Determine the Amount of Discount

As the issue price is lower than the face value of the bond, hence, this is a case of discount bond. The discount can be calculated as: \(600000 - 527368.90 = 72631.10 .\)

03

Effects on Financial Statements

On the balance sheet, both the assets and liabilities increase. In assets, cash account will increase by an amount equivalent to the bond issue price, here \$527368.90, while in liabilities, long term bonds will increase by face value i.e. \$600000 and discount on bond issued will be \$72631.10.

04

Amortization of Discount

The semi-annual amortization is calculated as: \((72631.10)/12 = 6052.59\). After each period, the discount on bond is reduced by this amount and at the end of 2 years (or 4 periods), the discount on bond becomes \(72631.10 - 6052.59 * 4 = 72631.10 - 24210.36 = 48420.74\)

05

Cash Paid at each Interest Date

Under normal circumstances, cash will be paid at each interest date will be the semi-annual coupon payment, here \$24000.

06

Determine Carrying Value after Two Years

The carrying value two years after the date of issue is computed as: Face Value of bond - discount on bond after 2 years = \$600000 - 48420.74 = \$551579.26

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Key Concepts

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

Interest Rate

The interest rate on a bond greatly influences its market price. It can affect whether a bond will be sold at a premium or a discount. There are two key rates to understand here:

• Coupon Rate: This is the interest rate the bond issuer promises to pay bondholders on the face value of the bond until maturity. In this exercise, Zany Sam's bond had a coupon rate of 8%.
• Market Yield: This is the interest rate that investors require, based on the risk and time until maturity of similar bonds in the market. Zany Sam's bonds had a market yield of 12%, which is higher than the coupon rate, leading to the bond being issued at a discount.

Understanding these rates clarifies why bonds might be sold for less than their face value when the required yield exceeds the stated coupon.

Financial Statements

When a company issues bonds, it impacts its financial statements, specifically its balance sheet and income statement. Here's how:

• Assets: The cash account increases by the amount of cash received from issuing the bond. In our example, Zany Sam's received $527,368.90 cash.
• Liabilities: Long-term liabilities increase by the bond's face value of $600,000. There's also an account for the bond discount, representing the difference between the bond's face value and its issue price.
• Equity: At issuance, equity does not change directly, but interest expenses over time will affect net income and thus retained earnings.

It's important to note that while this adjustment initially involves only the balance sheet, interest payments and discount amortization will later impact the income statement.

Bond Discount

A bond discount occurs when bonds are issued for less than their face value. This happens when the market interest rate is higher than the bond's coupon rate. Here's a deeper look into how this works:

• The issue price of Zany Sam's bond was $527,368.90, lower than the $600,000 face value, resulting in a discount of $72,631.10.
• A bond discount is amortized over the life of the bond. This means that the discount amount is gradually reduced as part of the interest expense during each period.
• In our example, the bond's discount is amortized semiannually, reducing the discount by $6,052.59 every period.

The amortization of the bond discount increases the amount of interest expense reported over time, affecting the company's profitability.

Balance Sheet

The balance sheet is a crucial component of a company's financial statements, reflecting its financial position at a point in time. Here's how bond issuance affects the balance sheet:

• Assets: When bonds are issued, the cash account under current assets increases by the bond's issue price, for Zany Sam's $527,368.90.
• Liabilities: Long-term liabilities, particularly bonds payable, rise by the bond's face value of $600,000. There is also an initial entry for the bond discount of $72,631.10, which is a contra-liability account reducing the total bond payable amount visible on the balance sheet.
• Changes Over Time: As the bond discount is amortized each period, the bond's book value or carrying amount increases, reflecting in the liabilities section as it approaches the face value of the bond by maturity.

Understanding the balance sheet impacts helps in assessing both the immediate and long-term financial obligations of a business due to bond issuance.