Debt is classified as short-term (ST) and long-term (LT).

• Current liabilities result from both operating and financing activities.
  • Those caused by operating activities include accounts payable and advances from customers. Operating and trade debt is reported at the expected (undiscounted) cash flow and is an important exception to the rule that liabilities are recorded at present value. Note that advances from customers are the consequence of operating decisions, the result of normal activity. They should be distinguished from other payables when analyzing a firm's liquidity. Advances are a prediction of future revenues rather than cash outflows.

  • Those resulting from financing activities include short-term (ST) debt and the current portion of long-term (LT) debt. They are recorded at present value. Note that the current portion of LT debt is the consequence of financing activity and indicates a need for cash or refinancing. A shift from operating to financing indicates the beginning of liquidity problems, and inability to repay ST credit is a sign of financial distress.

• Long-term debt results from financing activities. It may be obtained from many sources that may differ in interest and principal payments. Some claims are below or subordinated to others while other claims may be senior or have priority. Whatever the different payment terms are, there are two basic principles:
  • Debt equals present value of the future interest and principal payments. For book values the discount rate is the rate when debt was incurred. For market values the discount rate is the current rate.

  • Interest expense is the amount paid to the creditor in excess of the amount received. Though the total to be paid is known, allocation to specific time periods may be uncertain. The coupon rate is just the stated cash interest rate.

Below we will focus on debt resulting from financing activities.

Bond premiums and discounts:

• A bond premium represents the amount over the face value of the bond that the issuer never has to return to the bondholders. In effect it reduces the higher-than-market interest rate that the issuer is paying on the bond. It must be allocated over the life of the bond as a reduction of interest expense each period.
• A bond discount represents the amount in excess of the issue price that must be paid by the issuer at the time of maturity. In effect it increases the lower-than-market interest rate the issuer is paying on the bond. It must be allocated over the life of the bond as an increase of interest expense each period.

At the time of issuance, the firm receives proceeds from issuing the bond. A bond payable is valued at the present value of its future cash flows (periodic coupon payments and principal repayment at maturity). These cash flows are discounted at the market rate of interest at issuance. Therefore, the value of the bond depends on the market rate of interest. For example, if the market rate of interest is higher than the coupon rate, the bond value will be less than its face value, and the bond is issued at a discount.

• Balance sheet. Initial liability is the amount paid to the issuer by the lender. The amount may not equal to the face value of the bond.
  • Issued at par on Interest Date:
    If $800,000 of bonds were issued on January 1, 2015 at 100, the issuance would be recorded as follows:
    
  • Issued at Discount on Interest Date:
    If $800,000 of bonds were issued on January 1, 2015 at 97, the issuance would be recorded as follows:
    
  • Issued at Premium on Interest Date:
    If $800,000 of bonds were issued on January 1, 2015 at 103, the issuance would be recorded as follows:
    

• Cash flow statement. Cash flow from financing (CFF) increases by the amount received.

At the end of each semi-annual payment period, the firm makes a coupon payment:

• Income statement. Interest expense is reported here. The effective interest rate is the market rate at the time of issuance, and the interest expense is market rate multiplied by the bond liability at the beginning of this six-month period.

• Cash flow statement. Cash flow from operations (CFO) decreases by the coupon payment. The coupon rate and face value are used to calculate actual cash flows only.

• Balance sheet. The bond liability is adjusted if necessary. Liability over time is a function of (1) initial liability and the relationship of (2) interest expense to (3) the actual cash payments. That is, the difference between interest expense and coupon payment represents the change in bond liability during this period: change in bond liability = interest expense - coupon payment. The ending bond liability = beginning bond liability + change in bond liability.
  The bond premium or discount is amortized over the life of the bond by what is known as the interest method. This results in a constant rate of interest (not a constant interest expense) over the life of the bond. Bond interest expense is increased by amortization of a discount and decreased by amortization of a premium.
  • If the bond is issued at a premium, interest expense is always lower than coupon payment, and decreases over time. In this case the interest expense is only one component of the coupon payment. The rest of the coupon payment is used to amortize the bond's premium.
  • If the bond is issued at a discount, interest expense is always higher than coupon payment, and increases over time. In this case the interest expense has two components: the coupon payment and amortization amount of the bond's discount.
  • If the bond is issued at par, interest expense equals coupon payment.
  At any point in time the liability on the balance sheet will equal the present value of the remaining cash flow payments to the creditor discounted at the effective market interest rate.

At the maturity date, the firm repays the face value of the bond. The treatment and effects of the last coupon payment are the same as those shown above.

• Balance sheet: the bond liability is reduced by the face value.
• Cash flow statement: similar to the treatment of initial cash received, the final face value payment is treated as CFF.

Total interest expense is equal to amounts paid by the issuer to the creditor in excess of the amount received.

Summary of the Effective Interest Method

• Bond interest expense is computed first by multiplying the carrying value of the bonds at the beginning of the period by the effective interest rate:
  Interest Expense = Beginning Carrying Value x Market Rate of Interest

• The bond discount or premium amortization is then determined by comparing the bond interest expense with the interest to be paid. Note that Interest Payment = Face Value x Coupon Rate x 1/2 (assume semi-annual coupon payment).

• The carrying value of the bond at the end of the period = Beginning Carrying Value - Amortization of Bond Premium (or + Amortization of Bond Discount).

This method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. Since the percentage is the effective rate of interest incurred by the borrower at the time of issuance, the effective interest method results in a better matching of expense with revenues than the straight-line method.

Example

Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2015, due on January 1, 2020, with interest payable each July 1 and January 1. Since investors required an effective interest rate of 10%, they paid $92,278 for the $100,000 of bonds, creating a $7722 discount.

1. To record the issuance:

2. To record the first interest payment of $4,000 on July 1, 2015:

Note: 92,278 x 0.10 x 0.5 = $4,614. Now the discount balance is 7,722 - 614 = $7,108.

3. To record the second interest payment of $4,000 on January 1, 2016:

Note: (100,000 - 7,108) x 0.10 x 0.5 = $4,645. Now the discount balance is 7,108 - 645 = $6,463.

And so on.

• The carrying value of a premium (discount) bond decreases (increases) over time.
• At the maturity date, the carrying value of both a premium bond and a discount bond equals the face value.
• The interest expense of a discount (premium) bond increases (decreases) over time due to the increasing (decreasing) carrying value.

Zero-Coupon Bond

Zero-coupon bond has no periodic interest payments and is issued at a large discount from par. The proceeds at issuance equal the present value of the face value, discounted at the market value of interest at issuance. Repayment at maturity includes all the (implied) interest expense (equal to face value minus the proceeds) from the time of issuance: Total Implied Interest = Par Value - Proceeds Received.

In essence, zero-coupon bonds are a special type of discount bonds. Therefore, their effects on financial statements are similar to those of discount bonds.

• The interest expense on a zero-coupon bond never reduces operating cash flow. Reported CFO is systematically "overstated" when a zero-coupon (or deep-discount) bond is issued, while CFF is understated by the amortization amount of the discount and should be adjusted accordingly.
• Unlike discount bonds (whose reported CFO is reduced by the coupon payments), they make no coupon payments so they have no effect on reported CFO.
• Solvency ratios, such as cash-basis interest coverage, are improved relative to the issuance of par bonds. The cash eventually required to repay the obligations may become a significant burden.

For example, assume a market interest rate of 5%, a $100,000 face value zero-coupon bond payable in three years will be issued at $86,229.68 (semi-annual compounding). This is computed by pressing the following calculator keys: 100000 FV; 2.5I/Y; 6N; CPT PV.

The journal entry (of the issuer) to record this issue will be:
Bank (balance sheet): $86,229.68 (debit)
Bond liability (balance sheet): $86,229.68 (credit).

When the bond is paid at maturity, the repayment of $100,000 includes $13,770.32 of interest. The major difference between a zero-coupon and a par value bond is that the interest of $13,770.32 is never reported as a cash flow from operations for a zero-coupon bond.

This is because the full $100,000 is reported as a cash flow from financing.

Practice Question 1

When bonds are issued at a discount, the long-term liability reported on the balance sheet for the bonds ______

A. decreases or increases each year, depending on the stated interest rate.
B. increases each year during the life of the bond.
C. decreases each year during the life of the bond.

Correct Answer: B

The discount is amortized each period in the amount of the difference between the interest expense and the interest paid. As the discount is amortized, the book value of the liability will increase until it reaches maturity value.

Practice Question 2

If a company issues debt at a premium, and it uses the effective interest method to account for interest and premium amortization, the debt's interest expense and its book value, respectively, will behave as follows over the term of the bond issue:

A. increase; decrease
B. decrease; decrease
C. decrease; increase

Correct Answer: B

Under the effective interest method, the interest expense is computed using the effective rate times the book value of the bond. The amortization will decrease the premium, which will decrease the book value of the bond. The interest expense will also decrease, as it is based upon the decreasing book value of the bond.

Practice Question 3

Which one of the following best illustrates the relationship between the face amount of a non-interest-bearing note and its present value?

A. The face amount of the note is the same as the present value.
B. The relationship depends on the prevailing interest rate.
C. The face note amount is greater than the present value.

Correct Answer: C

The face amount of the note includes imputed interest and is greater than the present value, which is the known or implied cash price.

Practice Question 4

On January 1, 2015, the Liz-Beth Company issued zero-coupon bonds for $68,301, which resulted in an effective interest rate of 10 percent. The bonds' face value was $100,000 and the maturity date was January 2019. The amount of the discount to be amortized in 2015 is closest to ______.

A. $0
B. $6,830
C. $8,000

Correct Answer: B

The interest expense is $6,830 ($68,301 x 0.10), which is also the amount of the discount to be amortized.

Practice Question 5

Which of the following statements regarding zero-coupon bonds is not true?

A. Zero-coupon bonds frequently sell at a deep discount.
B. Zero-coupon bonds are popular with borrowers because interest expense is not recognized for financial accounting purposes until the maturity date.
C. If a company uses the effective interest method, the periodic interest expense recognized by the bond issuer will be a smaller amount in the early years of the bond's life than in later years.
D. For zero-coupon bonds, the periodic interest expense recognized is greater than the periodic cash interest payments made.

Correct Answer: B

When there are zero-coupon bonds, there are no cash payments for interest; however, interest expense is recognized each period for the amount of the discount that is amortized.

Practice Question 6

The price paid by investors for bonds payable is determined by ______.

A. market conditions
B. bond issuers
C. underwriters

Correct Answer: A

Bonds are priced so that the true rate of interest is equal to the market rate at the time of the bond sale.

Practice Question 7

For a bond issue that sells for more than the face amount of the bonds, the market rate of interest is ______

A. less than the interest rate stated in the bond indenture.
B. the same as the interest rate stated in the bond indenture.
C. determined using the interest rate stated in the bond indenture.

Correct Answer: A

A bond will sell at a premium (for more than the face amount of the bonds) when the market rate of interest is lower than the stated interest rate, due to demand for the bonds from investors.

Practice Question 8

Laker Corporation issued $250,000 in 20-year bonds payable, with 6% interest payable annually. At the time of the bond issuance, the market rate for similar quality investments was 5%. Present value factors are:

PVIF of $1, 20 periods, 5%, .37689
PVIF of $1, 20 periods, 6%, .31180
PVIF of Annuity of $1, 20 periods, 5%, 12.46221
PVIF of Annuity of $1, 20 periods, 6%, 11.46992

Laker's entry to record the sale is:

A. Cash (debit): 218,844
Bond discount (debit): 31,156
Bonds payable (credit): 250,000

B. Cash (debit): 281,156
Bond premium (credit): 31,156
Bonds payable (credit): 250,000

C. Cash (debit): 250,000
Bond premium (debit): 31,156
Bonds payable (credit): 281,156

D. Cash (debit): 281,156
Bond discount (credit): 31,156
Bonds payable (credit): 250,000

Correct Answer: B

Cash received is ($ 250,000 x .37689) + ($ 15,000 x 12.46221), or $281,156, which is greater than the bonds' face amount. The premium is $31,156 ($281,156 - $250,000). The 5% effective rate is used to compute cash received; the 6% coupon rate is used to compute the annual interest payment.

Practice Question 9

Gemstone Company issued $1,000,000 of 20-year, 6% bonds. The carrying value at the issue date is $980,000. The market rate of interest at the issue date is ______.

A. exactly equal to 6%
B. greater than 6%
C. less than 6%

Correct Answer: B

The bonds were issued at a discount (the carrying amount is lower than the face amount) because the market rate (also called yield rate or effective rate) is higher than the coupon rate. The discount compensates investors for the unattractively low coupon rate.

Practice Question 10

When a company has floating-rate debt outstanding, which party benefits from an increase in market interest rates?

A. The company issuing the bonds
B. The investment banker
C. The bond investor

Correct Answer: C

The bond investor benefits from an increase in interest rates because the issuing company will pay more interest than before. When market interest rates increase, LIBOR also increases.

Practice Question 11

What is the major advantage of debt financing?

A. Financial leverage
B. Interest expense is deductible in computing taxable income.
C. Fixed commitment to pay interest and principal
D. Little risk

Correct Answer: A

The major advantage of debt financing is that financial leverage can magnify shareholder returns.

Practice Question 12

On January 1, 2013, Brick Landing Corporation issued $5 million in bonds payable at a premium that matures on 12/31/2022. It is now 2015 and interest rates have risen compared to rates when the bonds were issued. The proper valuation for the bonds payable on 12/31/2015 is ______.

A. discounted present value using the historical effective yield rate (or carrying value)
B. discounted present value using the current effective yield rate
C. the lower of cost or market price

Correct Answer: A

Bonds payable are valued at the discounted present value of the future cash flow, using the yield rate that was effective when the bonds were issued.

Practice Question 13

On March 15th, 2016, Hyatt Company sold goods in exchange for a $20,000, 8% note receivable. The note required that 5 annual payments of $5,009 be made. The present value of the note (using a market rate of 9%) equaled the fair market value of the goods: $19,485. What is the total amount of interest revenue to be recorded by Hyatt over the life of this note?

A. $5,045
B. $5,560
C. $8,000

Correct Answer: B

The total interest revenue to be recorded over the life of the note is the difference between the total annual payments received ($25,045) and the present value of the note ($19,485) on the exchange date. The face value of the 8% note is not relevant here.

Practice Question 14

On January 1, Pathways Corporation sells $500,000 of 10-year, 5% bonds at a yield of 6%. The bonds pay interest annually each December 31. At the time of the sale, the bond discount was $36,818. What is the interest expense for that year?

A. $23,159
B. $27,791
C. $30,000

Correct Answer: B

Interest expense is based on the carrying value of the bonds, which is the face value less the discount ($500,000 - $36,818, or $463,182). Interest expense is $27,791 ($463,182 x .06 effective rate).

Practice Question 15

Orchard Company issued $2,000,000 of 8% debenture bonds on 7/1/2015 for $1,752,000. This resulted in an effective yield (market rate) of 10%. The bonds pay interest semi-annually on 1/1 and 7/1 and mature in ten years on 7/1/2025. If Orchard uses the effective interest method of amortization, how much of the bond discount should be amortized during the second semi-annual period ending 7/1/2016?

A. $12,400
B. $7,600
C. $7,980

Correct Answer: C

Interest expense for the period is equal to the carrying value of the bonds x effective interest rate. Interest paid is $80,000, which equals the face value x stated interest rate (2 million x .04 semi-annually) and remains the same over the life of the bonds. The discount amortization from the first interest period, $7,600 (87,600 - 80,000), is added to the $1,752,000 to obtain the carrying value of $1,759,600 for the start of the second semi-annual period. 87,600= 1,752,000 x .05. Thus, the discount amortization during the second semi-annual period is $87,980 (1,759,600 x .05) - $80,000 or $7,980.

Practice Question 16

When a firm issues zero-coupon debt instead of coupon debt, ______

A. cash flow from operations is higher.
B. the interest paid at the retirement date is reported in the cash flows from operations.
C. interest expense will decrease each year.
D. the times interest earned ratio will be constant each year.

Correct Answer: A

If zero-coupon debt is issued, there are no interest payments to be made each period and therefore no decreases in cash flow from operations because of interest payments.

Practice Question 17

The amount of bond discount amortized each semi-annual period under the effective interest method continues to increase over the life of the bond. True or False?

Correct Answer: True

The effective interest (interest expense) is higher than the interest paid on the bonds when a discount applies. The discount amortization is the difference between these two values. Since the expense calculation is based on the carrying value of the bonds (face amount - discount balance), which continually increases over the life of the bonds, the amortization of the discount also increases each period.

Practice Question 18

A firm decides to issue zero-coupon debt rather than full-coupon debt. The effect on net income over the life of the debt is that interest on zero-coupon bond ______

A. rises each year and hence the net income decreases over the life of the debt.
B. falls each year and hence the net income decreases over the life of the debt.
C. falls each year and hence the net income increases over the life of the debt.

Correct Answer: A

The effect on net income over the life of the debt is that interest on the zero-coupon bond rises each year and hence the net income decreases over the life of the debt.

Practice Question 19

When a company has floating-rate debt, it periodically revalues its debt for changes in the market rate of interest. True or False?

Correct Answer: False

Since the contract interest rate of floating-rate debt changes as the market rate changes, the book value of the debt is always exactly equal to its market value. Also, under GAAP, firms may not make entries to change the value of any type of debt due to changing interest rates.

Practice Question 20

Interest on a note payable is most appropriately accrued ______

A. when the note is signed.
B. as of the end of each accounting period during which the note is a liability.
C. when principal payments on the note are made.
D. when the interest is paid.
E. at its maturity date.

Correct Answer: B

Practice Question 21

The Mod Company issued a zero-coupon bond on January 1, 20x0, due December 31, 20x4. The face value of the bond was $100,000. The bond was issued at an effective rate of 14% (compounded annually). The CFO before interest and tax in each year is $60,000. EBIT in each year is $70,000.

The times interest earned in 20x2 is ______.

Correct Answer: 7.407

Interest expense = (51,937 + 7,271 + 8,289) x 14% = $9,450

Times interest earned = EBIT/interest = 70,000/9,450 = 7.407

Practice Question 22

A company issued 6-year, 10% bonds on September 1, 2015, for $91,619. The bonds have a maturity value of $100,000 and pay interest semi-annually on March 1 and September 1. The market rate of interest at the date of issue was 12%. The company has an accounting year-end of December 31. The amount of interest expense on March 1, 2016, is ______.

A. $1,832
B. $1,839
C. $2,000

Correct Answer: A

The interest expense for the six months from September 1, 2015, to March 1, 2016, would be $5,497 ($91,619 x .06). On December 31, 2015, four months would be recognized in the amount of $3,665 ($5,497 x 4/6). The rest of the interest, two months, would be recognized on March 1, 2016. This amount would be $1,832 ($5,497 - $3,665).

Practice Question 23

When bonds are issued at a premium, the long-term liability reported on the balance sheet for the bonds ______

A. decreases each year during the life of the bond.
B. increases each year during the life of the bond.
C. decreases or increases each year, depending upon the current market rate.

Correct Answer: A

When bonds are issued at a premium (an amount greater than face), the premium is amortized until it reaches zero. As the premium is decreased, the book value of the liability will decrease until it reaches face value at maturity.

Practice Question 24

Kiawah Corp. sold bonds at a price of 96.2 plus accrued interest. At the time of this issuance, the carrying value of the bonds would be less than:

Face Value of the Bonds : Cash Received by Kiawah (ignore fees)

A. Yes : Yes
B. Yes : No
C. No : Yes

Correct Answer: A

Since the carrying value (face value less discount) at issuance is equal to the purchase price, the carrying amount would be less than both the face value (price of 100) and the cash received, since the latter includes accrued interest.

Practice Question 25

Oakmont Corporation issued $100,000 of callable bonds on 1/1/2015 at a coupon rate of interest of 7%. The bonds sold at a discount which resulted in an effective yield of 8% to the bond investors. On January 1, 2016, the yield on these bonds fell to approximately 7% as market conditions led to an increase in bond prices. What change, if any, should Oakmont make to its accounting records to reflect the change in the yield?

A. Increase the carrying value of the bonds payable
B. Compute future interest expense based on the 7% new effective rate
C. No change is made to the accounting records.

Correct Answer: C

The only yield used to compute the carrying value is the one in effect when the bonds are sold. After that time, the bonds are always valued at that historical cost adjusted for amortization.

Practice Question 26

Abbey Company issued $1,000,000 of 10-year bonds with a contractual interest rate of LIBOR + 2%. The interest rate is to be reset annually. Bondholders will receive interest annually. The LIBOR for 2015 is 5.5%. The entries to record interest expense for 2015 are ______.

A. Interest expense (debit) 55,000; Discount on bonds payable (debit) 20,000; Accrued interest payable (credit) 75,000
B. Interest expense (debit) 75,000; Discount on bonds payable (credit) 20,000; Accrued interest payable (credit) 55,000
C. Interest expense (debit) 75,000; Accrued interest payable (credit) 75,000

Correct Answer: C

Floating rate debt is almost always issued at par, so there is no premium or discount to be amortized. Interest expense is debited for $75,000 which is the face value of $1 million x the interest rate of 7.5% (the LIBOR of 5.5% plus 2%).

Practice Question 27

In reference to the Discount on Bonds Payable and Premium on Bonds Payable accounts, which statement is true?

A. The Discount on Bonds Payable account is a contra asset.
B. The Discount on Bonds Payable account is amortized by a credit entry each period.
C. As the Premium on Bonds Payable account is amortized each period, the Interest Expense account is increased to the amount it would have been had the bonds been sold at par.

Correct Answer: B

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Practice Question 28

Deerfield Industries has just issued 5% annual coupon bonds with a face value of $75,000,000 at a market yield of 4.75%. The bonds have a 10 year maturity. How much interest expense and CFO will Deerfield report for the first year?

A. Interest expense of 3,750,000 and CFO of -3,750,000
B. Interest expense of 3,632,114 and CFO of -3,632,114
C. Interest expense of 3,632,114 and CFO of -3,750,000

Correct Answer: C

The market value of bonds at the time of issuance is calculated by discounting future cash flows at the market yield of 4.75%. Coupon payments are based on 5% of face value of 75,000,000.

Bond issue value: PMT = 3,750,000; N = 10; I/Y = 4.75; FV = 75,000,000; CPT PV = 76,465,565
Deerfield will show a bond liability of 76,465,565 and CFF equal to the face value, 75,000,000.
Year 1 interest = 0.0475 x 76,465,565 = 3,632,114. Deerfield will show an interest expense of 3,632,114 and a CFO of -3,750,000 (i.e., 5% of face value).

Practice Question 29

Jorgensen Products has just issued $25,000,000 in 4.50% annual coupon bonds at a market yield of 4.80%. The bonds have a maturity of 8 years. What adjustments would an analyst make to the CFO at the end of the first year?

A. Increase by 51,543
B. Decrease by 51,543
C. Decrease by 488,681

Correct Answer: B

Proceeds of bond issue: PMT = 1,125,000; I/Y = 4.80; FV = 25,000,000; N = 8; CPT PV = 24,511,316

Jorgensen will recognize this as a liability. Its annual interest will be 0.048 x 24,511,316 = 1,176,543.

Jorgensen records a CFO of -1,125,000 based on the coupon payment. The analyst would reduce the CFO by 51,543 to reflect the higher interest cost (= 1,176,543 - 1,125,000). Thus, CFO would be reduced by 51,543.

Practice Question 30

Jorgensen Products has just issued 25,000,000 in 4.50% annual coupon bonds at a market yield of 4.80%. The bonds have a maturity of 8 years. What adjustments would an analyst make to the CFF at the end of the first year?

A. Decrease by 51,543
B. Decrease by 488,681
C. Increase by 51,543

Correct Answer: C

Proceeds of bond issue: PMT = 1,125,000; I/Y = 4.80; FV = 25,000,000; N = 8; CPT PV = 24,511,316

Jorgensen will recognize this as a liability. Its annual interest will be, interest = 0.048 x 24,511,316 = 1,176,543

Jorgensen records a CFO of -1,125,000 based on the coupon payment. The analyst would reduce the CFO by 51,543 to reflect the higher interest cost (= 1,176,543 - 1,125,000).

The CFF would have to be increased by the same amount, 51,543, to reflect the fact that this differential interest is owed and will be paid at maturity. Thus, CFF will have to be increased by 51,543.

Practice Question 31

On January 1, 2015, the Liz-Beth Company issued zero-coupon bonds for $68,301, which resulted in an effective interest rate of 10%. The bonds' face value was $100,000 and the maturity date was January 1, 2019. What would be the amount of interest paid in 2015?

A. $0
B. $6,830
C. $10,000

Correct Answer: A

Zero-coupon bonds have no stated interest rate and do not pay interest.

Practice Question 32

The Mod Company issued a zero-coupon bond on January 1, 20x0, due December 31, 20x4. The face value of the bond was $100,000. The bond was issued at an effective rate of 14% (compounded annually). The CFO before interest and tax in each year is $60,000. EBIT in each year is $70,000.

The cash proceeds of the bond issue are ______.

A. $51,937
B. $100,000
C. $60,000

Correct Answer: A

Cash proceeds on a bond: 100,000/(1.14)⁵ = $51,937

Practice Question 33

The Mod Company issued a zero-coupon bond on January 1, 20x0, due December 31, 20x4. The face value of the bond was $100,000. The bond was issued at an effective rate of 14% (compounded annually). The CFO before interest and tax in each year is $60,000. EBIT in each year is $70,000.

The times interest earned in 20x4 is ______.

A. 5.7
B. 6.85
C. 1.46

Correct Answer: A

Interest expense = (51,937 + 7,271 + 8,289 + 9,450 + 10,773) x 14% = $12,281

Times interest earned = EBIT/interest = 70,000/12,281 = 5.7

Practice Question 34

Assume U.S. GAAP. At the beginning of the year, a company issues a $1,000 face value, semi-annual coupon, bond with an 8% coupon rate maturing in 10 years. The annual market rate of interest at issuance was 12%. The initial liability recorded for this bond is closest to ______.

A. $718
B. $771
C. $779

Correct Answer: B

The liability recorded is based on market rate of interest when the bond is issued and not the coupon rate on the bond. The market value of the bond at issuance was $770.60. (FV=1,000, PMT=40, N=20, I=6.0)

Practice Question 35

At the beginning of the year, two companies issued debt with the same market rate, maturity date, and total face value. One company issued coupon-bearing bonds at par and the other company issued zero-coupon bonds. All other factors being equal for that year, compared with the company that issued par bonds, the company that issued zero-coupon debt will most likely report ______

A. higher cash flow from operations but not higher interest expense.
B. neither higher cash flow from operations nor higher interest expense.
C. both higher cash flow from operations and higher interest expense.

Correct Answer: A

When a company issues a zero-coupon bond, cash flow from operations is overstated over the life of the bond. Interest expense is recorded for income statement purposes, but is added back in the statement of cash flows as a non-cash adjustment to cash flow from operations.

Practice Question 36

A company presents its financial statements according to U.S. GAAP and has just issued $5 million of mandatory redeemable preferred shares with a par value of $100 per share and a 7% dividend. The issue matures in 5 years. Which of the following statements is least likely correct? At the time of the issue, the company's ______

A. debt-to-total-capital ratio will improve.
B. interest coverage ratio will deteriorate.
C. preferred shareholders will rank below debt-holders should the company file for bankruptcy.

Correct Answer: A

SFAS 150 requires that issuers report as liabilities any financial instruments that will require repayment of principal in the future. Mandatory redeemable preferred shares must be reported as debt; dividends on such stock must be reported as interest expense (consistent with the view that the preferred stock is debt), which will lower the interest coverage ratio.

In the Debt/(Debt + Equity) ratio, the Debt will increase making the debt/total capital increase (the numerator will increase more than the denominator); thus, the ratio will increase (deteriorate), not decrease (improve).

Practice Question 37

A company issued a $50,000 7-year bond for $47,565. The bond pays 9 percent per annum and the yield-to-maturity at issue was 10 percent. The company uses the effective interest rate method to amortize any discounts or premiums on bonds. After the first year, the yield to maturity on bonds equivalent in risk and maturity to these bonds is 9 percent. The amount of the bond discount amortization recorded in the second year is closest to ($) ______.

A. 223
B. 282
C. 343

Correct Answer: B

Interest paid = Market rate at issue x Issued amount of bonds = 9% x $50,000
Interest expense = Market rate at issue x Carrying (BV) of bonds
Amortization of discount = Interest expense - Interest paid

Year 0 carrying value: 47,565
Year | 1 | 2
Interest paid | 4,500 | 4,500
Interest expense | 4,757 | 4,782
Amortization of discount | 257 | 282
Carrying value | 47,822 | 48,104

Amortization in the 2nd year is 282.