Chapter 14

Planning Debt Financing

MATCHING

1. Match the following terms with the descriptions below.

A. Carrying value of debt

B. Collateral

C. Discount on a note

D. Face rate on the note

E. Face value of the note

F. Holder of the note

G. Lump-sum payment note

H. Maker of the note

I. Market, or, effective interest rate

J. Mortgage

K. Periodic payment and lump-sum note

L. Periodic payment note

M. Premium on a note

N. Proceeds of the note

_____ 1. When the present value or cash proceeds of a note exceeds the face value of

the note

_____ 2. Also known as a noninterest bearing note

_____ 3. The borrower who signs the note

_____ 4. The liability of a note at a specified time

_____ 5. The amount the borrower will repay the lender for principal

_____ 6. A lender

_____ 7. The assets named in the debt agreement that the lender can have if the

borrower fails to comply with the terms of the note

_____ 8. The cash raised by issuing a note

_____ 9. Also known as an installment note

_____10. The actual interest rate charge on the proceeds of a note

_____11. A long-term note secured with real estate

_____12. A note with periodic payments based on a face rate and a promise to pay a

final lump-sum at the maturity date

_____13. The excess of the face value over the proceeds of the note

_____14. The interest rate used to determine the cash interest paid by the note

Answers: 1. M; 2. G; 3. H; 4. A; 5. E; 6. F; 7. B; 8. N; 9. L; 10. I; 11. J; 12. K; 13. C; 14. D

2. Match the following terms with the descriptions below.

A. Bearer bond

B. Bond

C. Bond indenture

D. Callable bond

E. Convertible bond

F. Covenants

G. Debenture bonds

H. Mortgage bonds

I. Registered bonds

J. Secured bond

K. Serial bond

L. Subordinated bonds

_____ 1. A bond issue that has specific portions of the bond issue coming due

periodically over the life of the bond issue

_____ 2. A bond secured with real estate

_____ 3. A bond that is payable to whomever has physical possession of the bond

_____ 4. A bond that allows the company issuing the bond to buy the bond back at a set

price

_____ 5. A long-term note issued to the public

_____ 6. Bonds that are numbered and made payable in the name of the bondholders

_____ 7. Unsecured bonds whose repayment ranks after other debt securities in the

event the firm is liquidated

_____ 8. Restrictions place on the borrowing company to protect the lender

_____ 9. Bonds with no specific assets pledged as collateral

_____10. A bond contract

_____11. A bond that pledges specific assets of the corporation to the bondholders in

the event the company defaults on the bond issue

_____12. A bond feature that allows the bondholder to exchange the bond for a

specified number of common or preferred stock

Answers: 1. K; 2. H; 3. A; 4. D; 5. B; 6. I; 7. L; 8. F; 9. G; 10. C; 11. J; 12. E

3. Match the following with the descriptions listed below.

1. Premium
2. Discount
3. Capital Lease
4. Operating Lease
5. Noninterest-bearing note
6. Installment note
7. Bond
8. Bond Indenture

_____ 1. Rental agreement that requires the recognition of interest

_____ 2. Borrowing money from the public

_____ 3. Market interest rate > Face interest rate

_____ 4. Legal financing agreement between borrower and lender

_____ 5. Most car loans

_____ 6. Rent expense

_____ 7. Only one cash payment during life of the note

_____ 8. Market interest rate < Face interest rate

Answers: 1. C; 2. G; 3. B; 4. H; 5. F; 6. D; 7. E; 8. A

MULTIPLE CHOICE

4. Documented restrictions that lenders place in the debt agreements for firms using their funds are called:

A) covenants.

B) debentures.

C) subordinates.

D) preemptive rights.

5. The amount of cash raised from the issuance of debt is referred to as the:

A) redemption value.

B) effective value.

C) maturity value.

D) cash proceeds

6. George Ryan obtained a car loan that requires him to make payments of $235 per month for 36 months. This is an example of a:

A) lump-sum note.

B) periodic payment note.

C) noninterest-bearing note.

D) periodic and lump-sum note.

7. Glenda Corp obtained a loan that required the company to make only payment at the end of 5 years. This is an example of:

A) a noninterest-bearing note.

B) a periodic payment note.

C) an interest-bearing note.

D) An installment note.

8. When the cash proceeds of a note less than the face value of a note the difference is called the:

A) discount on the note.

B) market value of the note.

C) effective rate of the note.

D) carrying value of the note.

9. When the market rate of interest is greater than the face rate of interest, which of the following is created?

A) A premium

B) A discount

C) A face value

D) None of the above

10. When a note is issued at a premium, which of the following is true?

A) The market rate is less than the face rate.

B) The market rate is greater than the face rate.

C) The proceeds of the note are less than the face value of the note.

D) The proceeds will equal the face value.

11. When the proceeds of a note are less than the face value of the note, which of the following is true?

A) The market rate was less than the face rate of interest.

B) The note was issued at a premium.

C) The market rate of interest was greater than the face rate of interest.

D) The market rate of interest was the same as the face rate of interest.

12. When a note is issued at a discount, which of the following is not true?

A) The borrower gets less cash than the face value.

B) The interest expense is greater than cash paid for interest during a period.

C) Cash repaid at maturity is less than face value of the note.

D) The market rate of interest is greater than face rate of interest on the note.

13. The cash proceeds from a note is dependent on which of the following?

A) Market interest rate

B) Face interest rate

C) Face value of the note

D) All of the above

14. When a note is issued at a discount, the carrying value of a note is equal to the:

A) face value of the note less the discount.

B) face value of the note plus the discount.

C) market value of the note less the discount.

D) market value of the note plus the discount.

15. When the market rate of interest is less than a note’s face rate of interest,

A) the note is issued at a discount.

B) the note is issued at a premium.

C) the proceeds of the note are less than the face value of the note.

D) unable to determine from the information given.

16. When the market rate of interest is greater than a note’s face rate of interest,

A) the note is issued at a discount.

B) the note is issued at its face value.

C) the proceeds of the note are greater than the face value of the note.

D) unable to determine from the information given.

17. When the market rate of interest is less than the note’s face rate of interest, which of the following is not true?

A) The cash proceeds of the note will be less than the face value.

B) The cash interest paid will be less than the interest expense.

C) The note will be issued at a premium.

D) The cash paid at the maturity of the note will be the same as the face value.

18. When the present value of a note’s promised cash flows is equal to the note’s face value,

A) the note is issued at a discount.

B) the note is issued at a premium.

C) the market rate of interest is less than the face rate of interest.

D) the face rate of interest and the market rate of interest are the same.

19. When leased property is recognized as an asset and a related liability is recorded, the lease is a(n):

A) legal lease.

B) capital lease.

C) certified lease.

D) operating lease.

20. A noninterest-bearing note is always issued:

A) at its face value.

B) at a premium.

C) at a discount

D) whether it is issued at a premium or discount depends on the market interest rate.

21. A $1,000 bond with a quoted price of 97 3/4 is selling for:

A) $ 97.75.

B) $970.75.

C) $977.50.

D) $97,750.00.

22. A $1,000 bond with a quoted price of 103 3/4 is selling for:

A) $103.75.

B) $1033.40.

C) $1030.75.

D) $1300.75.

23. A long-term debt instrument issued by a corporation to raise money from the public is called:

A) preferred stock.

B) common stock.

C) a mortgage.

D) a bond.

24. In a debt instrument, named assets that creditors will receive if the borrower defaults on the note are called:

A) collateral.

B) covenants.

C) debentures.

D) leveraged assets.

25. A long-term note secured by land or buildings that serve as collateral, is referred to as a:

A) mortgage.

B) debenture.

C) property dividend.

D) subordinated note.

26. A bond issue that specifies that certain portions of the total bond issue are due periodically over the life of the bond is called a:

A) serial bond.

B) bond indenture.

C) registered bond.

D) redeemable bond.

27. Cabal Company issued debentures with a face interest rate of 6 percent and a market interest rate of 5 percent. How will interest expense compare to the cash interest paid each period?

A) Interest expense will be greater

B) Interest expense will be less

C) They will be equal

D) Unable to determine from the information given

28. On January 1, 2010, Complot Corporation issued debentures with a face interest rate of 6 percent and a market interest rate of 7 percent. How will interest expense in 2010 compare with cash interest paid and due in 2010?

A) It will be the same.

B) It will be greater.

C) It will be less.

D) Unable to determine from the information given.

29. Which of the following statements about convertible bonds is/are true?

A) Conversion of bonds into stock is at the issuing firm’s option.

B) Convertible bonds usually have a higher interest rate than nonconvertible bonds.

C) The bonds will be converted only if the value of the stock is greater than the value of the bonds.

D) All of the above are true.

30. Bonds with a face interest rate receive cash proceeds equal to the present value of the:

A) principal to be paid at the maturity date.

B) interest to be paid over the term of the bonds.

C) interest to be paid over the term of the bonds plus the present value of the principal to be paid at the maturity date.

D) interest to be paid over the term of the bonds minus the present value of the principal to be paid at the maturity date.

31. The cash interest paid on a note during a period is equal to the:

A) maturity value multiplied times the face interest rate.

B) maturity value multiplied times the effective interest rate.

C) carrying value at the beginning of the period multiplied times the face interest rate.

D) carrying value at the beginning of the period multiplied times the effective interest rate.

32. The interest expense on a note during a period is equal to the:

A) maturity value multiplied times the face interest rate.

B) maturity value multiplied times the effective interest rate.

C) carrying value at the beginning of the period multiplied times the face interest rate.

D) carrying value at the beginning of the period multiplied times the effective interest rate.

33. The total amount of interest expense over the life of a note is:

A) the face value times the face interest rate times the number of interest payments over the life of the note.

B) the face value of the note times the market interest rate times the number of interest payments over the life of the note.

C) the total of the cash outflows of the note over the life of the note less the proceeds of the note.

D) the proceeds of the note plus the cash interest paid less the maturity value of the note.

34. A firm that makes extensive use of long-term liabilities to meet its financing needs is:

A) using financial leverage.

B) likely to default on these liabilities.

C) could be more profitable for its owners than one that doesn’t use long-term liabilities.

D) both a and c are correct.

35. If a firm’s bonds payable are issued at a discount, it is apparent that:

A) at the issue date, the face interest rate was less than the market interest rate.

B) the firm will be able to pay off the bonds for less than maturity value.

C) the bonds must be convertible.

D) the bonds have a low rating.

38. Convertible bonds may dilute existing stockholders’ interest in the corporation. This means that:

A) convertible bonds reduce common stockholders’ earnings because they must pay a higher interest rate than nonconvertible bonds.

B) the amount of cash paid out when the convertible bonds are converted will reduce common stockholders’ dividends.

C) the shares issued for convertible bonds have a preference over other common shares.

D) conversion of the bonds would increase the number of common shares outstanding.

39. When convertible bonds are exchanged for common stock which of the following is NOT true?

A) The debt-to-equity ratio will go down.

B) Interest expense will decrease.

C) The times-interest-earned ratio will go up.

D) The bond will not have to be paid at its maturity date.

E) All of the above are true.

40. When convertible bonds are exchanged for common stock which of the following is not true?

A) The debt-to-equity ratio will go up.

B) Interest expense will decrease.

C) Times-interest-earned ratio will go up.

D) The bond will not have to be paid at its maturity date.

41. All other factors being equal, a $1,000,000, 10-year, 8 percent face rate convertible bond will differ how from a $1,000,000, 10-year, 8 percent nonconvertible bond?

1. Lower market rate of interest and higher cash proceeds
2. Higher market rate of interest and smaller cash proceeds
3. Same Market interest rate and same cash proceeds
4. Lower market interest rate and smaller cash proceeds

42. All things being equal, a convertible bond will have:

A) a higher market interest rate than a comparable nonconvertible bond.

B) a lower market interest rate than a comparable nonconvertible bond.

C) the same market interest rate as a comparable nonconvertible bond.

D) no impact on the market interest rate of the bond.

43. Carter & Cash has just acquired equipment by issuing a $500,000, 2-year, noninterest-bearing note. The equipment was recorded on the books at $500,000. What is the result of this?

A) The financial statements are correct.

B) Net income is overstated and assets are understated.

C) Net income is overstated and liabilities are overstated.

D) Assets, liabilities, and stockholders’ equity are all understated.

44. What does discount on a note payable represent?

A) Loss from borrowing

B) Gain from borrowing

C) Additional interest expense over the term of the note

D) Additional interest revenue over the term of the note

45. How should interest expense on a noninterest-bearing note be determined?

A) There is no interest expense on a noninterest-bearing note.

B) By dividing the discount on the note by the number of years till maturity

C) By multiplying the face amount of the note times the market rate of interest

D) By multiplying the carrying value of the note times the market rate of interest

46. Spurt Company issued a 3-year, noninterest-bearing note on January 1, 2010. At what amount should the note be reported on the December 31, 2010, balance sheet?

A) Face amount

B) Face amount plus discount amortized

C) Face amount plus unamortized discount

D) Face amount minus unamortized discount

47. Although each payment of an installment note is the same amount, which of the following statements is true?

A) All payments will cover the same amount of interest and principal.

B) The first payments will cover more interest expense than the later payments.

C) The first payments will cover more principal than the later payments.

D) The first installment payments cover interest until it is paid and then the remaining payments cover the repayment of the principal.

48. Why would a lessee rather have an operating lease than a capital lease?

A) Operating leases do not require reporting long-term liabilities.

B) Capital leases would require larger lease payments.

C) Operating leases permit a tax deduction for depreciation.

D) Noncancelable operating leases involve less risk.

49. If Walker Corporation issues a $1,000,000 three-year noninterest-bearing note, how much cash will it receive if the interest rate is 10 percent compounded semiannually?

A) $1,000,000

B) $564,474

C) $746,215

D) $751,315

50. Ellis Corporation wants to raise $500,000 by issuing a five-year, noninterest-bearing note when the market rate is 8 percent compounded quarterly. What will the face value of the note be?

A) $336,486

B) $742,974

C) $734,664

D) $340,291

51. Trego Corporation issued a five-year $70,000 installment note with a market interest rate of 9 percent and 60 monthly payments. What is the amount of the monthly payments?

A) $1,453.08

B) $1,166.67

C) $5,812.84

D) $14,316

52. Grainfield Corporation first payment on an 8 percent, $40,000, 10-year installment, that has quarterly payments is $1,462.23. How much of this first payment is interest?

A) $116.98

B) $800

C) $633.56

D) $320

53. Park Corporation issued a 10-year $10,000,000 bond that had an 8 percent face interest rate that is paid semi-annually when the market interest rate was 6 percent. What are the proceeds generated by this bond issue?

A) $10,000,000

B) $14,265,101

C) $11,487,747

D) $11,472,017

54. Studley Company issued a 5-year $5,000,000 bond that had an 8 percent face interest rate that is paid annually when the market interest rate was 10 percent. What are the proceeds of the bond issue?

A) $5,000,000

B) $4,376,889

C) $5,671,008

D) $4,385,543

55. The carrying value of a $500,000, 4-year note with an 8 percent face rate (paid semiannually) that was issued to yield a 7 percent market rate is $515,286.36. What is the interest expense for the next interest period?

A) $20,000

B) $18,035.02

C) $20,611.45

D) $36,070.04

56. The carrying value of a $500,000, 4-year note with an 8 percent face rate (paid semi-annually) that was issued to yield 9 percent is $491,031.19. What is the interest expense for the next interest period?

A) $20,000.00

B) $19,641.25

C) $22,096.40

D) $44,192.81

57. Which of the following is NOT true about a capital lease?

A) The entire amount of each lease payment is considered rent expense.

B) It is used when the assets leased is in substance purchased.

C) When a capital lease is used, an asset is recorded and depreciated over its useful life.

D) When a capital lease is used, interest expense is incurred on each payment.

58. When considering how to finance the acquisition of an asset, which of the following statements is true?

A) The amount borrowed should be larger than the cost of the assets acquired.

B) The cash flows generated by the assets should dictate the type of note (noninterest bearing, installment, etc.) the company uses to finance the asset.

C) The cash flow required by the type of note used should dictate the type of asset acquired.

D) In order to minimize debt the company should not borrow unless there is no cash to fund the acquisition of the asset.

59. Which of the following is NOT a true statement about bonds?

A) A company that issues bonds is (typically) borrowing money from the public not a specific person or institution.

B) A bond’s prices in the secondary market changes as the market interest changes over time.

C) Bonds can be turned in by their holders prior to their maturity date and receive the bond’s face value.

D) When a company issues convertible bonds it will not have to pay the face value of the bonds if the bonds are converted before the bond’s maturity date.

60. “Obviously, there is no interest expense on a noninterest-bearing note.” Is this statement accurate? Explain.

61. "All other things being equal, a convertible bond should sell at a higher price than

a straight bond." Is this statement accurate? Why or why not?

62. Alhambra Corporation is trying to decide between raising needed money by borrowing on a noninterest-bearing note, by issuing an ordinary bond or issuing convertible bonds. Which will probably result in the smallest interest expense?

63. Dighton Corporation is considering issuing a 4 year $500,000 noninterest-bearing note, a 4-year annual payment, 8 percent face rate, $500,000 installment note, or a 4-year, $500,000, 10 percent note. If the market interest rate is 8 percent answer the following:

A. Which note will generate the most cash and which will generate the least?

B. Which note is the most expensive way to borrow fund?

Answers:

A. The interest-bearing note will generate more than its face value because it will be issued at a premium; the noninterest-bearing note will have the lowest proceed because it will be issued at a discount.

B. All the notes pay the same rate of interest, 8 percent, so they are all the same. Although the interest expense will be different for each note, the actual cost of using borrowed funds is the same.

64. Once the capital budgeting decision has identified the asset the firm wants to acquire and

the decision is made to use debt financing, how does the firm decide between a

noninterest-bearing note, an installment note, or an interest bearing note?

65. Given a market interest rate of 8 percent, which of the following will generate the largest

cash proceeds and which one has highest borrowing rate?

Note A. $1,000,000, 20-year, 7 percent face interest rate

Note B. $1,000,000, 20-year, 8 percent face interest rate

Note C. $1,000,000, 20-year, 9 percent face interest rate

66. Boweil Industries is purchasing a new piece of equipment for its manufacturing facilities. The list price of the equipment is $75,000, but the dealer is willing to finance the equipment at 0 percent interest for 30 months. The financing agreement calls for 30 monthly installment payments of $2,500 each. Boweil’s normal cost of borrowing for this type of financing arrangement is 12 percent annually. What value should Boweil assign to the equipment and the note if the deal is accepted?

67. Bandaks Enterprises authorized the issuance of $6,000,000 of 10-year, 8 percent bonds dated March 1, 2010, with semi-annual interest payment dates of September 1 and March 1. Determine the cash proceeds from the sale of the bonds on March 1, 2010 if the bonds are sold to yield 10 percent.

68. You have just purchased a new Mercedes for $65,000. You have made a $12,000 down payment and have signed an installment note for the $53,000. The note has an interest rate of 8 percent and calls for you to make 20 quarterly payments starting three months from today. What will be the amount of each quarterly payment on this loan? How much of the first payment will be principal and how much will be interest?

69. You have just purchased a new home for $265,000. You have made a $20,000 down payment and have signed an installment note for the $245,000. The note has an interest rate of 5 percent and calls for you to make 120 monthly payments starting one month from today. What will be the amount of each payment on this loan? How much of the first payment will be principal and how much will be interest?

70. If a company wants to raise $40,000 using a 5-year noninterest-bearing note, what would be the face value of the note if the market rate is 10 percent compounded annually? What is the interest incurred on the note in the first year of its life?

71. Ogallah Corporation wants to raise $100,000 using a 10-year non–interest-bearing note,

What would be the face value of the note if the market interest rate for Ogallah at the

time they signed the note was 6 percent compounded annually? What is the interest incurred on the note for the first two years of the note’s life?

72. On Sept 1, 2010 Innsbrook Corporation has just issued a $1,000,000 note. The note will have a 10-year life and a 12 percent face rate of interest that is paid annually.

If the market rate of interest for the note is 10 percent, what will be the proceeds of the note (how much cash will be the maker of the note will receive)?

Set up an amortization table for the note for the two years of the note’s life. How much cash interest will Innsbrook pay during the first year of the note’s life? How much interest expense will the note incur during the second year of the note’s life?

73. On April 1, 2010 Boston Corporation issued a $2,000,000 note. The note will have a 10-year life and a 6 percent face rate of interest that is paid annually.

If the market rate of interest for the note is 8 percent what will be the proceeds of the note (how much cash will be the maker of the note will receive)?

Set up an amortization table for the note for the two years of the note’s life. How much cash interest will Boston pay during the first year of the note’s life? How much interest expense will the note incur during the second year of the note’s life?

74. On November 1, 2010 Michigan Iron works arrange to purchase a $150,000 piece of

equipment by making a 20 percent down payment and signing a 3-year installment loan contract with interest at 8 percent per year for the balance. The loan is to be repaid in semi-annual installments starting on May 1, 2011.

Required:

(A) How much cash will the company pay out in 2010? Where will the cash outflows appear in the financial statements?

(B) How much interest expense will the company incur from November 1, 2010 to November 1, 2011?

(C) How much of the debt will be reduced in the first year of the note?

(D) How will the installment note be reported on the balance sheet on December 31, 2010?

Answers:

(A) $22,891.59 x 2 = $45,783.18 because these payments reduce a liability, they would appear on the cash flow statement in the financing section.

(B) $4,800.00 + $4,076.34 = $8,876.34

(C) $18,091.59 + $18,815.25 = $36,906.84

(D) The $120,000 of principal will be divided into two parts in the liability section. $36,906.84 of the debt will be reported as a current liability. The remaining $83,093.16 will be reported as a long-term liability.

75. The Barton Leasing Company recently purchased printing equipment for $185,296 and wants to lease it to Triple J News Service. If Triple J accepts, it will sign the lease agreement on December 1, 2010. The equipment has a useful life of 5 years, and the lease term is for five years. During the year Triple J is responsible for all repairs and maintenance of the leased property. The lease agreement calls for Triple J to make 5 annual lease payments of $43,705 starting December 1, 2010. The interest rate is 9 percent. Triple J has asked you to help it plan for the impact of the lease.

Required:

(A.) What makes this a capital lease?

(B.) What is the value of the equipment and the amount of the liability generated by the transaction?

(C.) Prepare a lease payment schedule for the first three lease payments.

(D.) What is the interest cost in each of the first two years of the lease’s life?

(E.) How is the lease reported on December 31, 2010 on the balance sheet?

Answers:

(A.) This is a capital lease because the useful life of the equipment (5 years) and the life of the lease payments (5 years) are the same and in substance the lessee has purchased the equipment.

(B.) The value of the equipment on Triple J’s books is $185,296, which is the present value of the future cash flows.

(C.) Triple J’s liability after the first lease payment (which is on the first day of the lease) is $141,591 ($185,296 – $43,705).

(D.) First year of the lease interest cost is $12,743 and the second year of the lease interest cost is $9,956.

(E.) The lease liability is reduced with the initial payment leaving a $141,591 liability on December 31, 2010. Of this amount $30,961 will be reported as current as current and $110,629 is reported as long-term liabilities.

76. Sprint is planning to issue debentures with a face value of $10,000,000 on September 1, 2010. The debentures mature in 10 years and have a face interest rate of 8 percent that is paid semiannually on March 1 and September 1 of each year. Sprint thinks the market interest rate will be 6%. Assume that Sprint has a fiscal year end on Aug 31.

Required:

(A) Calculate the proceeds of the bond and set up an amortization schedule for the first year of the bond’s life.

(B) Where will the proceeds of the bond be reported on the budgeted financial statements?

(C) What is the amount of interest expense Sprint will incur in the first year of the bond’s life and where will the interest be reported on the budgeted financial statements for August 31, 2011?

(D) How will the bond be reported on the budgeted balance sheet on August 31, 2011?

Answers:

(A)

A × P20,3% = PV

$400,000 × 14.8775 = PV

$5,951,000 = PV

FV × p20,3% = PV

$10,000,000 × 0.5537 = PV

$5,537,000 = PV

$ 5,951,000 PV of Cash Interest

5,537,000 PV of Bond’s Face Value

$11,488,000 Cash Proceeds from the Bond

or

FV = 10,000,000, ANN = $400,000, r = 6, c = 2, n = 20 PV = ? = 11,487,747.49

(B) The proceed of the bond $11,487,747 will be reported in the financing section of the cash flow statement as an inflow of cash.

(C) The interest expense for the first year will be $344,632 + $342,971 = $687,603, and that amount will be reported on the income statement.

(D) The bond will be reported as long-term debt on the balance sheet in the amount of $11,378,351.

77. Klocke Corporation is planning to issue debentures with a face value of $10,000,000 on September 1, 2010. The debentures mature in 10 years and have a face interest rate of 8 percent that is paid semi-annually on March 1 and September 1 of each year. Klocke thinks the market interest rate will be 10%. Assume that Klocke has a fiscal year-end on Feb 28.

Required:

(A) Calculate the proceeds of the bond and set up an amortization schedule for the first year of the bond’s life.

(B) Where will the proceeds of the bond be reported on the budgeted financial statements?

(C) What is the amount of interest expense Klocke will incur in the first year of the bond’s life? What amount and where will the interest be reported on the budgeted financial statements for 2011.

(D) How will the bond be reported on the budgeted balance sheet for 2011.

Answers:

(A) Market rate is 10 percent.

A × P20,5% = PV

$400,000 × 12.4622 = PV

$4,984,880 = PV

FV × p20,5% = PV

$10,000,000 × .3769 = PV

$3,769,000 = PV

$4,984,880 PV of Cash Interest

3,769,000 PV of Bond’s Face Value

$8,753,880 Cash Proceeds from the Bond

$ 8,753,880 Cash Proceeds from the Bond

10,000,000 Face Value of the Bond

$ 1,246,120 Discount on the bond

OR

FV = 10,000,000, ANN = $400,000, r = 10, c = 2, n = 20 PV = ? = $8,753,778.96

(B) The proceed of the bond, $8,753,880, will be reported in the financing section of the cash flow statement as an inflow of cash.

(C) The interest expense for the first year will be $437,694 + $439,579 = $877,273 and $437,694 will be reported on the income statement for the year ended Feb 28, 2004.

(D) The bond will be reported as long-term debt on the balance sheet in the amount of $8,791,574