Chapter 15 BONDS PAYABLE and investments in bonds
advertisement
CHAPTER 15 BONDS PAYABLE AND INVESTMENTS IN BONDS QUESTION INFORMATION Number EO15-1 EO15-2 EO15-3 EO15-4 EO15-5 EO15-6 EO15-7 EO15-8 EO15-9 EO15-10 EO15-11 EO15-12 EO15-13 EO15-14 EO15-15 PE15-1A Objective 15-2 15-2 15-2 15-2 15-2 15-2 15-2 15-2 15-3 15-3 15-3 15-3 15-4 15-5 15-6 15-1 PE15-1B 15-1 PE15-2A 15-2 PE15-2B 15-2 PE15-3A 15-2 PE15-3B 15-2 PE15-4A 15-3 PE15-4B 15-3 PE15-5A 15-3 PE15-5B 15-3 PE15-6A 15-3 PE15-6B 15-3 PE15-7A 15-3 PE15-7B 15-3 Description Determining the effect of alternative financing plans on earnings per share Determining the effect of alternative financing plans on earnings per share Determine the present value of a future amount Determine the present value of a future amount Determine the present value of a bond Determine the present value of a bond Record the issuance of bonds payable Record the issuance of bonds payable Record the interest for bonds payable Record the interest for bonds payable Record the issuance of bonds payable Record the issuance of bonds payable Record the interest for bonds payable Record the interest for bonds payable Difficulty Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Time 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min AACSB Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic AICPA FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement 811 SS GL Number PE15-8A Objective 15-4 PE15-8B 15-4 PE15-9A 15-5 PE15-9B 15-5 Ex15-1 15-1 Ex15-2 15-1 Ex15-3 Ex15-4 15-1 15-2 Ex15-5 15-2 Ex15-6 15-2 Ex15-7 15-2 Ex15-8 15-2, 15-3 Ex15-9 15-2, 15-3 Ex15-10 Ex15-11 15-2, 15-3 15-3 Ex15-12 15-3 Ex15-13 15-2, 15-3 Ex15-14 15-3, 15-4 Ex15-15 15-3, 15-4 Ex15-16 Ex15-17 15-4, 15-6 15-5 Ex15-18 15-5 Ex15-19 15-5 Ex15-20 FAI Ex15-21 Appendix Description Record the redemption of bonds payable Record the redemption of bonds payable Record the purchase of a bond investment Record the purchase of a bond investment Effect of financing on earnings per share Evaluating alternative financing plans Corporate financing Present value of amounts due Present value of an annuity Present value of an annuity Present value of an annuity Present value of bonds payable, discount Present value of bonds payable, premium Bond price Entries for issuing bonds Entries for issuing bonds and amortizing discount by straightline method Computing bond proceeds, entries for bond issuing, and amortizing premium by straight-line method Entries for issuing and calling bonds, loss Entries for issuing and calling bonds, gain Reporting bonds Amortizing discount on bond investment Entries to purchase and sale of investments in bonds, loss Entries to purchase and sale of investments in bonds, gain Number of times interest charges earned Amortize discount by interest method Difficulty Easy Time 5 min AACSB Analytic AICPA FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 10 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy Easy 5 min 10 min Analytic Analytic FN-Measurement FN-Measurement Easy 10 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy 5 min Analytic FN-Measurement Easy Easy 5 min 10 min Analytic Analytic FN-Measurement FN-Measurement Easy 15 min Analytic FN-Measurement Easy 10 min Analytic FN-Measurement Easy 10 min Analytic FN-Measurement Easy 10 min Analytic FN-Measurement Easy Easy 5 min 5 min Analytic Analytic FN-Measurement FN-Measurement Easy 10 min Analytic FN-Measurement Easy 10 min Analytic FN-Measurement Easy 10 min Analytic FN-Measurement Easy 15 min Analytic FN-Measurement 812 SS GL Number Ex15-22 Objective Appendix Ex15-23 Appendix Ex15-24 Appendix Pr15-1A 15-1 Pr15-2A 15-2, 15-3 Pr15-3A 15-2, 15-3 Pr15-4A 15-3, 15-4 Pr15-5A 15-5 Pr15-6A Appendix Pr15-7A Appendix Pr15-1B 15-1 Pr15-2B 15-2, 15-3 Pr15-3B 15-2, 15-3 Pr15-4B 15-3, 15-4 Pr15-5B 15-5 Pr15-6B Appendix Pr15-7B Appendix Description Amortize premium by interest method Computing bond proceeds, amortizing premium by interest method, and interest expense Compute bond proceeds, amortizing discount by interest method, and interest expense Effects of financing on earnings per share Present value, bond premium, entries for bonds payable transactions Present value, bond discount, entries for bonds payable transactions Entries for bonds payable transactions Entries for bond investments Entries for bonds payable transactions, interest method of amortizing bond premium Entries for bonds payable transactions, interest method of amortizing bond discount Effects of financing on earnings per share Present value, bond premium, entries for bonds payable transactions Present value, bond discount, entries for bonds payable transactions Entries for bonds payable transactions Entries for bond investments Entries for bonds payable transactions, interest method of amortizing bond premium Entries for bonds payable transactions, interest method of amortizing bond discount Difficulty Moderate Time 15 min AACSB Analytic AICPA FN-Measurement Moderate 15 min Analytic FN-Measurement Moderate 15 min Analytic FN-Measurement Moderate Analytic FN-Measurement Moderate 1 1/2 hr 1 hr Analytic FN-Measurement KA Moderate 1 hr Analytic FN-Measurement KA Moderate 1 hr Analytic FN-Measurement Exl KA Moderate Analytic FN-Measurement Exl KA Moderate 1 1/4 hr 45 min Analytic FN-Measurement Moderate 45 min Analytic FN-Measurement Moderate Analytic FN-Measurement Moderate 1 1/2 hr 1 hr Analytic FN-Measurement KA Moderate 1 hr Analytic FN-Measurement KA Moderate 1 hr Analytic FN-Measurement Exl KA Moderate Analytic FN-Measurement Exl KA Moderate 1 1/4 hr 45 min Analytic FN-Measurement Moderate 45 min Analytic FN-Measurement 813 SS GL Exl Exl Number Comp Problem 4 SA15-1 Objective 15-1, 15-2, 15-2, 15-4, 15-5, 15-6 15-2 SA15-2 15-2 SA15-3 SA15-4 15-2 15-1 SA15-5 SA15-6 SA15-7 15-2, 15-3 15-1 15-2 Description Journalize transactions, prepare financial statements General Electric bond issuance Ethics and professional conduct in business Present values Preferred stock vs. bonds Investing in bonds Investing in bonds Financing business expansion Difficulty Difficult Time 3 hr AACSB Analytic AICPA FN-Measurement Easy 5 min Ethics BB-Industry Easy 5 min Ethics BB-Industry Easy Easy 10 min 5 min Analytic Analytic FN-Measurement FN-Measurement Moderate Easy Moderate 15 min 20 min 30 min Analytic Analytic Analytic FN-Measurement FN-Measurement FN-Measurement 814 SS GL EYE OPENERS 1. (1) To pay the face (maturity) amount of the bonds at a specified date. (2) To pay periodic interest at a specified percentage of the face amount. 2. a. Bonds that may be exchanged for other securities under specified conditions. b. The issuing corporation reserves the right to redeem the bonds before the maturity date. c. Bonds issued on the basis of the general credit of the corporation. 3. The phrase “time value of money” means that an amount of cash to be received today is worth more than the same amount of cash to be received in the future. This is because cash on hand today can be invested to earn income. 4. (b) $9,000 to be received at the end of each of the next two years has the higher present value because cash that is received earlier can be invested to earn income. 5. Less than face amount. Because comparable investments in bonds provide a market interest rate (10%) that is greater than the rate on the bond being purchased (9%), the bond will sell at a discount as the market’s means of equalizing the two interest rates. 6. a. Greater than $5,000,000 b. 1. $5,000,000 2. 5% 3. 7% 4. $5,000,000 7. Less than the contract rate 8. a. Premium b. $125,000 c. Premium on Bonds Payable 9. a. Debit Interest Expense Credit Discount on Bonds Payable b. Debit Premium on Bonds Payable Credit Interest Expense 10. No. Because zero-coupon bonds do not provide for interest payments, they will sell at a discount. 11. The purpose of a bond sinking fund is to accumulate over the life of a bond issue enough funds to pay the indebtedness at the maturity date. 12. The bond issue that is callable is more risky for investors, because the company may redeem (call) the bond issue if interest rates fall. In addition, since the bonds may be called at their face amount, they will sell for a lower value than the noncallable bond issue. 13. A loss of $7,000 [($500,000 0.97) – ($500,000 – $22,000)] 14. Under the caption “Investments” 15. At their cost less any amortized premium or plus any amortized discount 815 PRACTICE EXERCISES PE 15–1A Earnings before bond interest and income tax ............... Bond interest ...................................................................... Balance ............................................................................... Income tax .......................................................................... Net income .......................................................................... Dividends on preferred stock ............................................ Earnings available for common stock .............................. Number of common shares ............................................... Earnings per share on common stock ............................. Plan 1 Plan 2 $400,000 120,0001 $280,000 112,0002 $168,000 0 $168,000 /100,000 $ 1.68 $400,000 60,0003 $340,000 136,0004 $204,000 140,000 $ 64,000 / 80,000 $ 0.80 Plan 1 Plan 2 $ 500,000 270,0001 $ 230,000 92,0002 $ 138,000 0 $ 138,000 / 150,000 $ 0.92 $ 500,000 216,0003 $ 284,000 113,6004 $ 170,400 120,000 $ 50,400 / 120,000 $ 0.42 1$1,000,000 × 12% × 40% 3$500,000 × 12% 4$340,000 × 40% 2$280,000 PE 15–1B Earnings before bond interest and income tax ............... Bond interest ...................................................................... Balance .............................................................................. Income tax .......................................................................... Net income .......................................................................... Dividends on preferred stock ............................................ Earnings available for common stock .............................. Number of common shares ............................................... Earnings per share on common stock ............................. 1$3,000,000 × 9% × 40% 3$2,400,000 × 9% 4$284,000 × 40% 2$230,000 PE 15–2A $3,558.45. [$7,000 × 0.50835 (Present value of $1 for 10 periods at 7%)] 816 PE 15–2B $1,357.05. [$3,000 × 0.45235 (Present value of $1 for 7 periods at 12%)] PE 15–3A Present value of face amount of $150,000 due in 10 years, at 7% compounded annually: $150,000 × 0.50835 (present value factor of $1 for 10 periods at 7%) .................... Present value of 10 annual interest payments of $10,500, at 7% interest compounded annually: $10,500 × 7.02358 (present value of annuity of $1 for 10 periods at 7%).................................................................. Total present value of bonds $ 76,252* 73,748 $150,000 *Rounded to the nearest dollar. PE 15–3B Present value of face value of $80,000 due in 5 years, at 10% compounded annually: $80,000 × 0.62092 (present value factor of $1 for 5 periods at 10%) .................... Present value of 5 annual interest payments of $8,000, at 10% interest compounded annually: $8,000 × 3.79079 (present value of annuity of $1 for 5 periods at 10%) ............. Total present value of bonds ......................................................... $ 49,674* 30,326* $ 80,000 *Rounded to the nearest dollar. PE 15–4A Cash ...................................................................................... Discount on Bonds Payable ................................................ Bonds Payable ................................................................ 463,202 36,798 500,000 PE 15–4B Cash ...................................................................................... Discount on Bonds Payable ................................................ Bonds Payable ................................................................ 817 1,330,403 169,597 1,500,000 PE 15–5A Interest Expense .................................................................. Discount on Bonds Payable........................................... Cash ................................................................................. Paid interest and amortized the bond discount ($36,798/20). 26,840 1,840 25,000 PE 15–5B Interest Expense .................................................................. Discount on Bonds Payable........................................... Cash ................................................................................. Paid interest and amortized the bond discount ($169,597/10). 76,960 16,960 60,000 PE 15–6A Cash ...................................................................................... Premium on Bonds Payable .......................................... Bonds Payable ................................................................ 2,154,429 154,429 2,000,000 PE 15–6B Cash ...................................................................................... Premium on Bonds Payable .......................................... Bonds Payable ................................................................ 1,065,040 65,040 1,000,000 PE 15–7A Interest Expense .................................................................. Premium on Bonds Payable ................................................ Cash ................................................................................. Paid interest and amortized the bond premium ($154,429/10). 818 104,557 15,443 120,000 PE 15–7B Interest Expense ..................................................................... Premium on Bonds Payable ................................................... Cash .................................................................................... Paid interest and amortized the bond premium ($65,040/20). 46,748 3,252 50,000 PE 15–8A Bonds Payable......................................................................... Loss on Redemption of Bonds .............................................. Discount on Bonds Payable.............................................. Cash .................................................................................... 700,000 45,000 60,000 685,000 PE 15–8B Bonds Payable......................................................................... Premium on Bonds Payable ................................................... Gain on Redemption of Bonds ......................................... Cash .................................................................................... 250,000 20,000 25,000 245,000 PE 15–9A a. 2008 Sept. 1 Investment in Maxtech Corporation Bonds ... Interest Revenue............................................... Cash ............................................................. b. 2008 Dec. 31 Investment in Maxtech Corporation Bonds ... Interest Revenue ......................................... *[($70,000 – $56,000)/111 months] × 4 months. 819 56,000 1,400 57,400 505* 505 PE 15–9B a. 2008 Mar. 1 Investment in PUA-Tech Corporation Bonds .... Interest Revenue.................................................. Cash ................................................................ b. 2008 Dec. 31 Investment in PUA-Tech Corporation Bonds .... Interest Revenue ............................................ *[($50,000 – $40,000)/111 months] × 10 months. 820 40,000 1,250 41,250 901* 901 EXERCISES Ex. 15–1 a. Earnings before bond interest and income tax .......... Bond interest ................................................................. Balance ........................................................................... Income tax ...................................................................... Net income ..................................................................... Dividends on preferred stock ....................................... Earnings available for common stock ......................... Bliss Co. $ 1,000,000 240,000 $ 760,000 304,000 $ 456,000 320,000 $ 136,000 Earnings per share on common stock ........................ $ b. Earnings before bond interest and income tax .......... Bond interest ................................................................. Balance ........................................................................... Income tax ...................................................................... Net income ..................................................................... Dividends on preferred stock ....................................... Earnings available for common stock ......................... c. 0.68 $ 1,800,000 240,000 $ 1,560,000 624,000 $ 936,000 320,000 $ 616,000 Earnings per share on common stock ........................ $ 3.08 Earnings before bond interest and income tax .......... Bond interest ................................................................. Balance ........................................................................... Income tax ...................................................................... Net income ..................................................................... Dividends on preferred stock ....................................... Earnings available for common stock ......................... $ 3,200,000 240,000 $ 2,960,000 1,184,000 $ 1,776,000 320,000 $ 1,456,000 Earnings per share on common stock ........................ $ 7.28 Ex. 15–2 Factors other than earnings per share that should be considered in evaluating financing plans include: bonds represent a fixed annual interest requirement, while dividends on stock do not; bonds require the repayment of principal, while stock does not; and common stock represents a voting interest in the ownership of the corporation, while bonds do not. 821 Ex. 15–3 Williams-Sonoma’s major source of financing is common stock. It has long-term debt, excluding current installments, of $14,490,000, compared to stockholders’ equity of $1,125,318,000. Ex. 15–4 a. $200,000/1.07 = $186,916 $186,916/1.07 = $174,688 $174,688/1.07 = $163,260 b. $200,000 × 0.81630 = $163,260 Ex. 15–5 a. First Year: $75,000 × 0.95238 = $ 71,428.50 Second Year: $75,000 × 0.90703 = 68,027.25 Third Year: $75,000 × 0.86384 = 64,788.00 Fourth Year: $75,000 × 0.82270 = 61,702.50 Total present value $265,946.25 b. $75,000 × 3.54595 = $265,946.25 Ex. 15–6 $2,000,000 × 12.46221 = $24,924,420 Ex. 15–7 No. The present value of your winnings using an interest rate of 10% is $17,027,120 ($2,000,000 × 8.51356), which is more than one-half of the present value of your winnings using an interest rate of 5% ($24,924,420; see Ex. 15–6). This is because of the effect of compounding the interest. That is, compound interest functions are not linear functions, but use exponents. 822 Ex. 15–8 Present value of $1 for 10 (semiannual) periods at 5% (semiannual rate) .......................... Face amount of bonds ............................................... Present value of an annuity of $1 for 10 periods at 5% .............................................. Semiannual interest payment ................................... Total present value (proceeds) ................................. 0.61391 × $20,000,000 × 7.72174 $900,000 $12,278,200 6,949,566 $19,227,766 Ex. 15–9 Present value of $1 for 10 (semiannual) periods at 5.5% (semiannual rate) ....................... Face amount of bonds ............................................... Present value of an annuity of $1 for 10 periods at 5.5% ........................................... Semiannual interest payment ................................... Total present value (proceeds) ................................. 0.58543 × $15,000,000 × 7.53763 $900,000 $ 8,781,450 6,783,867 $15,565,317 Ex. 15–10 The bonds were selling at a premium. This is indicated by the selling price of 108.89, which is stated as a percentage of face amount and is more than par (100%). The market rate of interest for similar quality bonds was lower than 6.375%, and this is why the bonds were selling at a premium. Ex. 15–11 May Nov. 1 1 Dec. 31 Cash ..................................................................... Bonds Payable ................................................ 12,000,000 Interest Expense ................................................. Cash ................................................................. 480,000 Interest Expense ................................................. Interest Payable .............................................. 160,000* *$12,000,000 × 8% × 2/12. 823 12,000,000 480,000 160,000 Ex. 15–12 a. 1. Cash .......................................................................... Discount on Bonds Payable .................................... Bonds Payable .................................................... 11,116,854 883,146 2. Interest Expense ...................................................... Cash ..................................................................... 600,000 3. Interest Expense ...................................................... Cash ..................................................................... 600,000 4. Interest Expense ...................................................... Discount on Bonds Payable .............................. $883,146/5 years = $176,629. 176,629 12,000,000 600,000 600,000 176,629 b. Annual interest paid ...................................................... Plus discount amortized ............................................... Interest expense for first year ...................................... $1,200,000 176,629 $1,376,629 Note: The following data in support of the proceeds of the bond issue stated in the exercise are presented for the instructor’s information. Students are not required to make the computations. Present value of $1 for 10 (semiannual) periods at 6% (semiannual rate) ........................ Face amount ........................................................ 0.55840 × $12,000,000 $ 6,700,800 Present value of annuity of $1 for 10 periods at 6% ....................................................... Semiannual interest payment ............................. × 7.36009 $600,000 4,416,054 Total present value of bonds payable................ 824 $11,116,854 Ex. 15–13 a. Cash ........................................................................... Premium on Bonds Payable ............................... Bonds Payable .................................................... 4,301,504 301,504 4,000,000 Note: The following data are in support of the determination of the proceeds of the bond issue stated in the exercise: Present value of $1 for 10 (semiannual) periods at 5.5% (semiannual rate) ..................... 0.58543 Face amount ............................................................. × $4,000,000 $ 2,341,720 Present value of an annuity of $1 for 10 periods at 5.5% .................................................... Semiannual interest payment .................................. Proceeds ................................................................... 1,959,784 $ 4,301,504 × b. Interest Expense ....................................................... Premium on Bonds Payable .................................... Cash ..................................................................... 7.53763 $260,000 229,850 30,150* 260,000** *$301,504/10 semiannual payments. **$4,000,000 × 13% × 6/12. Ex. 15–14 2008 Apr. 1 Oct. 1 2012 Oct. 1 Cash ..................................................................... Bonds Payable ................................................ 7,000,000 Interest Expense ................................................. Cash ................................................................. 315,000 Bonds Payable .................................................... Loss on Redemption of Bonds .......................... Cash ................................................................. 7,000,000 210,000 825 7,000,000 315,000 7,210,000 Ex. 15–15 2008 Jan. 1 July 1 2014 July 1 Cash ..................................................................... Bonds Payable ................................................ 4,000,000 Interest Expense ................................................. Cash ................................................................. 140,000 Bonds Payable .................................................... Gain on Redemption of Bonds ...................... Cash ................................................................. 4,000,000 4,000,000 140,000 160,000 3,840,000 Ex. 15–16 1. The significant loss on redemption of the series X bonds should be reported in the Other Income and Expense section of the income statement, rather than as an extraordinary loss. 2. The series Y bonds outstanding at the end of the current year should be reported as a noncurrent liability on the balance sheet because they are to be paid from funds set aside in a sinking fund. Ex. 15–17 The discount of $4,180 ($5,000 – $820) is amortized as interest revenue over the life of the bonds, using the straight-line method (illustrated in this chapter) or the interest method (illustrated in the appendix to this chapter). 826 Ex. 15–18 a. Investment in Sanhueza Co. Bonds ............................. Interest Revenue ............................................................ Cash .......................................................................... 612,000 10,500 b. Cash ................................................................................ Interest Revenue ...................................................... 21,000 c. 622,500 21,000 Interest Revenue ............................................................ Investment in Sanhueza Co. Bonds ....................... 960 d. Cash ................................................................................ Loss on Sale of Investments ........................................ Investment in Sanhueza Co. Bonds ....................... Interest Revenue ...................................................... 591,500 18,720 960 606,720 3,500 Ex. 15–19 a. Investment in Blaga Co. Bonds .................................... Interest Revenue ............................................................ Cash .......................................................................... 436,500 9,000 b. Cash ................................................................................ Interest Revenue ...................................................... 18,000 c. 445,500 18,000 Investment in Blaga Co. Bonds .................................... Interest Revenue ...................................................... 1,080 d. Cash ................................................................................ Investment in Blaga Co. Bonds .............................. Gain on Sale of Investments ................................... Interest Revenue ...................................................... 457,500 1,080 442,440 12,060 3,000 Ex. 15–20 a. Current year: Number of times interest charges earned: 6.6 = Preceding year: Number of times interest charges earned: 8.8 = $489,000,0 00 $88,000,00 0 $88,000,00 0 $708,000,0 00 $91,000,00 0 $91,000,00 0 b. The number of times interest charges earned has declined from 8.8 to 6.6 in the current year. Although Southwest Airlines has adequate earnings to pay interest, the decline in this ratio may cause concern among debtholders. 827 Appendix Ex. 15–21 a. 1. Cash .......................................................................... Discount on Bonds Payable .................................... Bonds Payable .................................................... 9,785,645 1,214,355 2. Interest Expense ...................................................... Cash ..................................................................... 495,000 3. Interest Expense ...................................................... Cash ..................................................................... 495,000 4. Interest Expense ...................................................... Discount on Bonds Payable .............................. 189,806 11,000,000 495,000 495,000 189,806 Computations: $9,785,645 × 6% = $587,139 $587,139 – $495,000 = $92,139 first semiannual amortization $9,785,645 + $92,139 = $9,877,784 $9,877,784 × 6% = $592,667 $592,667 – $495,000 = $97,667 second semiannual amortization $92,139 + $97,667 = $189,806 amortization for first year Note: The following data in support of the proceeds of the bond issue stated in the exercise are presented for the instructor’s information. Students are not required to make the computations. Present value of $1 for 10 (semiannual) periods at 6% (semiannual rate) ........................ Face amount ............................................................. Present value of annuity of $1 for 10 periods at 6% .................................................. Semiannual interest payment .................................. Total present value of bonds payable..................... 0.55840 × $11,000,000 $ 6,142,400 × b. Annual interest paid ...................................................... Plus discount amortized ............................................... Interest expense for first year ...................................... 828 7.36009 $495,000 3,643,245 $ 9,785,645 $ 990,000 189,806 $ 1,179,806 Appendix Ex. 15–22 a. 1. Cash .......................................................................... Premium on Bonds Payable .............................. Bonds Payable .................................................... 2,688,440 2. Interest Expense ...................................................... Cash ..................................................................... 162,500 3. Interest Expense ...................................................... Cash ..................................................................... 162,500 4. Premium on Bonds Payable .................................... Interest Expense ................................................. 30,077 188,440 2,500,000 162,500 162,500 30,077 Computations: $2,688,440 × 5.5% = $147,864 $162,500 – $147,864 = $14,636 first semiannual amortization $2,688,440 – $14,636 = $2,673,804 $2,673,804 × 5.5% = $147,059 $162,500 – $147,059 = $15,441 second semiannual amortization $14,636 + $15,441 = $30,077 first year amortization b. Annual interest paid ...................................................... Less premium amortized .............................................. Interest expense for first year ...................................... 829 $325,000 30,077 $294,923 Appendix Ex. 15–23 a. Present value of $1 for 10 (semiannual) periods at 5.5% (semiannual rate) ..................... 0.58543 Face amount ............................................................. × $22,000,000 $12,879,460 Present value of annuity of $1 for 10 periods at 5.5% .................................................... 7.53763 Semiannual interest payment .................................. × $1,540,000 Proceeds of bond sale ............................................. 11,607,950 $24,487,410 b. First semiannual interest payment ......................... 5.5% of carrying amount of $24,487,410 ................. Premium amortized .................................................. $ 1,540,000 1,346,808 $ 193,192 c. $ 1,540,000 1,336,182 $ 203,818 Second semiannual interest payment .................... 5.5% of carrying amount of $24,294,218* ............... Premium amortized .................................................. *$24,487,410 – $193,192 = $24,294,218 d. Annual interest paid ................................................. Less premium amortized ......................................... Interest expense for first year ................................. *$193,192 + $203,818 = $397,010. 830 $ 3,080,000 397,010* $ 2,682,990 Appendix Ex. 15–24 a. Present value of $1 for 10 (semiannual) periods at 5% (semiannual rate) ........................ 0.61391 Face amount ............................................................. × $27,500,000 $16,882,525 Present value of annuity of $1 for 10 periods at 5% ... 7.72174 Semiannual interest payment .................................. × $1,100,000 Proceeds of bond sale ............................................. 8,493,914 $25,376,439 b. 5% of carrying amount of $25,376,439 .................... First semiannual interest payment ......................... Discount amortized .................................................. $ 1,268,822 1,100,000 $ 168,822 c. $ 1,277,263 1,100,000 $ 177,263 5% of carrying amount of $25,545,261* .................. Second semiannual interest payment .................... Discount amortized .................................................. *$25,376,439 + $168,822 = $25,545,261. d. Annual interest paid ................................................. Plus discount amortized .......................................... Interest expense first year ....................................... *$168,822 + $177,263 = $346,085. 831 $ 2,200,000 346,085* $ 2,546,085 PROBLEMS Prob. 15–1A 1. Earnings before interest and income tax ...... Deduct interest on bonds ............................... Income before income tax .............................. Deduct income tax .......................................... Net income ....................................................... Dividends on preferred stock ......................... Available for dividends on common stock.... Shares of common stock outstanding .......... Earnings per share on common stock .......... Plan 1 $20,000,000 — $20,000,000 8,000,000 $12,000,000 — $12,000,000 / 4,000,000 $ 3.00 Plan 2 $20,000,000 — $20,000,000 8,000,000 $12,000,000 800,000 $11,200,000 / 2,000,000 $ 5.60 Plan 3 $20,000,000 1,600,000 $18,400,000 7,360,000 $11,040,000 400,000 $10,640,000 / 1,000,000 $ 10.64 2. Earnings before interest and income tax ...... Deduct interest on bonds ............................... Income before income tax .............................. Deduct income tax .......................................... Net income ....................................................... Dividends on preferred stock ......................... Available for dividends on common stock.... Shares of common stock outstanding .......... Earnings per share on common stock .......... Plan 1 $ 2,600,000 — $ 2,600,000 1,040,000 $ 1,560,000 — $ 1,560,000 / 4,000,000 $ 0.39 Plan 2 $ 2,600,000 — $ 2,600,000 1,040,000 $ 1,560,000 800,000 $ 760,000 / 2,000,000 $ 0.38 Plan 3 $ 2,600,000 1,600,000 $ 1,000,000 400,000 $ 600,000 400,000 $ 200,000 / 1,000,000 $ 0.20 832 Prob. 15–1A Concluded 3. The principal advantage of Plan 1 is that it involves only the issuance of common stock, which does not require a periodic interest payment or return of principal, and a payment of preferred dividends is not required. It is also more attractive to common shareholders than is Plan 2 or 3 if earnings before interest and income tax is $2,600,000. In this case, it has the largest EPS ($0.39). The principal disadvantage of Plan 1 is that it requires an additional investment by present common shareholders to retain their current interest in the company. Also, if earnings before interest and income tax is $20,000,000, this plan offers the lowest EPS ($3.00) on common stock. The principal advantage of Plan 3 is that little additional investment would need to be made by common shareholders for them to retain their current interest in the company. Also, it offers the largest EPS ($10.64) if earnings before interest and income tax is $20,000,000. Its principal disadvantage is that the bonds carry a fixed annual interest charge and require the payment of principal. It also requires a dividend payment to preferred stockholders before a common dividend can be paid. Finally, Plan 3 provides the lowest EPS ($0.20) if earnings before interest and income tax is $2,600,000. Plan 2 provides a middle ground in terms of the advantages and disadvantages described in the preceding paragraphs for Plans 1 and 3. 833 Prob. 15–2A 1. Cash ........................................................................ Premium on Bonds Payable ............................ Bonds Payable ................................................. *Present value of $1 for 20 (semiannual) periods at 6.5% (semiannual rate) .................. Face amount .......................................................... Present value of an annuity of $1 for 20 periods at 6.5% ................................................. Semiannual interest payment ............................... Proceeds of bond issue ........................................ 2. 844,077* 44,077 800,000 0.28380 × $800,000 11.01851 × $56,000 a. Interest Expense ................................................. Premium on Bonds Payable ($44,077/20) ......... Cash ................................................................ 53,796 2,204 b. Interest Expense ................................................. Premium on Bonds Payable ............................... Cash ................................................................ 53,796 2,204 $227,040 617,037 $844,077 56,000 56,000 3. $53,796 4. Yes. Investors will be willing to pay more than the face amount of the bonds when the interest payments they will receive from the bonds exceed the amount of interest that they could receive from investing in other bonds. 834 Prob. 15–3A 1. Cash ........................................................................... Discount on Bonds Payable .................................... Bonds Payable .................................................... 11,783,070* 716,930 12,500,000 *Present value of $1 for 20 (semiannual) periods at 6% (semiannual rate) ........................ 0.31180 Face amount ............................................................. × $12,500,000 Present value of an annuity of $1 for 20 periods at 6% ....................................................... 11.46992 Semiannual interest payment .................................. × $687,500 Proceeds of bond issue ........................................... 2. a. Interest Expense ................................................. Discount on Bonds Payable ($716,930/20) .................................................. Cash ................................................................ 723,347 b. Interest Expense ................................................. Discount on Bonds Payable ......................... Cash ................................................................ 723,347 $ 3,897,500 7,885,570 $11,783,070 35,847 687,500 35,847 687,500 3. $723,347 4. Yes. Investors will not be willing to pay the face amount of the bonds when the interest payments they will receive from the bonds are less than the amount of interest that they could receive from investing in other bonds. 835 Prob. 15–4A 1. 2007 July Dec. 2008 June Dec. 2009 July 1 Cash .............................................................. Premium on Bonds Payable .................. Bonds Payable ........................................ 20,880,780 31 Interest Expense .......................................... Cash ......................................................... 1,140,000 31 Premium on Bonds Payable ........................ Interest Expense ..................................... 134,341 31 Income Summary ......................................... Interest Expense ..................................... 1,005,659 30 Interest Expense .......................................... Cash ......................................................... 1,140,000 31 Interest Expense .......................................... Cash ......................................................... 1,140,000 31 Premium on Bonds Payable ........................ Interest Expense ..................................... 268,682 31 Income Summary ......................................... Interest Expense ..................................... 2,011,318 1 Bonds Payable ............................................. Premium on Bonds Payable ........................ Gain on Redemption on Bonds ............. Cash ($19,000,000 × 101.5%) ................. 19,000,000 1,343,416 2. a. b. 3. Initial carrying amount of bonds .................................. Premium amortized on December 31, 2007................. Premium amortized on December 31, 2008................. Carrying amount of bonds, December 31, 2008.......... 1,880,780 19,000,000 1,140,000 134,341 1,005,659 1,140,000 1,140,000 268,682 2,011,318 1,058,416 19,285,000 2007: $1,005,659 2008: $2,011,318 836 $20,880,780 (134,341) (268,682) $20,477,757 Prob. 15–5A 2007 Sept. 1 Dec. 31 31 2012 June 30 Oct. 31 31 Dec. 31 31 Investment in Wilson Company Bonds ............. Interest Revenue ($600,000 × 10% × 2/12) ........ Cash ................................................................. 578,580 10,000 Cash ..................................................................... Interest Revenue ............................................. 30,000 Investment in Wilson Company Bonds ............. Interest Revenue ............................................. *[($600,000 – $578,580)/238 months]x4. 588,580 30,000 360* 360 Cash ..................................................................... Interest Revenue ............................................. 30,000 Investment in Wilson Company Bonds ............. Interest Revenue ............................................. 450 30,000 450 Cash ..................................................................... 300,600* Loss on Sale of Investments ............................. 1,480 Investment in Wilson Company Bonds ......... Interest Revenue ............................................. *($300,000 × 0.97) + ($300,000 × 10% × 4/12) – $400 Cash ..................................................................... Interest Revenue ............................................. 15,000 Investment in Wilson Company Bonds ............. Interest Revenue ............................................. 540 837 292,080 10,000 15,000 540 Appendix Prob. 15–6A 1. a. Interest Expense ...................................................... Premium on Bonds Payable [$56,000 – (6.5% × $844,077)] .................................. Cash ..................................................................... 54,865 b. Interest Expense ...................................................... Premium on Bonds Payable [$56,000 – (6.5% × $842,942)] .................................. Cash ..................................................................... 54,791 1,135 56,000 1,209 56,000 2. $54,865 Appendix Prob. 15–7A 1. 2. a. Interest Expense ...................................................... Discount on Bonds Payable [($687,500 – (6% × $11,783,070)]........................ Cash ..................................................................... 706,984 b. Interest Expense ...................................................... Discount on Bonds Payable [$687,500 – (6% × $11,802,554)] ......................... Cash ..................................................................... 708,153 $706,984 838 19,484 687,500 20,653 687,500 Prob. 15–1B 1. Earnings before interest and income tax ...... Deduct interest on bonds ............................... Income before income tax .............................. Deduct income tax .......................................... Net income ....................................................... Dividends on preferred stock ......................... Available for dividends on common stock.... Shares of common stock outstanding .......... Earnings per share on common stock .......... Plan 1 $30,000,000 — $30,000,000 12,000,000 $18,000,000 — $18,000,000 / 7,500,000 $ 2.40 Plan 2 $30,000,000 — $30,000,000 12,000,000 $18,000,000 600,000 $17,400,000 / 3,750,000 $ 4.64 Plan 3 $30,000,000 1,200,000 $28,800,000 11,520,000 $17,280,000 300,000 $16,980,000 / 1,875,000 $ 9.06 2. Earnings before interest and income tax ...... Deduct interest on bonds ............................... Income before income tax .............................. Deduct income tax .......................................... Net income ....................................................... Dividends on preferred stock ......................... Available for dividends on common stock.... Shares of common stock outstanding .......... Earnings per share on common stock .......... Plan 1 $ 1,800,000 — $ 1,800,000 720,000 $ 1,080,000 — $ 1,080,000 / 7,500,000 $ 0.14 Plan 2 $ 1,800,000 — $ 1,800,000 720,000 $ 1,080,000 600,000 $ 480,000 / 3,750,000 $ 0.13 Plan 3 $ 1,800,000 1,200,000 $ 600,000 240,000 $ 360,000 300,000 $ 60,000 / 1,875,000 $ 0.03 839 Prob. 15–1B Concluded 3. The principal advantage of Plan 1 is that it involves only the issuance of common stock, which does not require a periodic interest payment or return of principal, and a payment of preferred dividends is not required. It is also more attractive to common shareholders than is Plan 2 or 3 if earnings before interest and income tax is $1,800,000. In this case, it has the largest EPS ($0.14). The principal disadvantage of Plan 1 is that it requires an additional investment by present common shareholders to retain their current interest in the company. Also, if earnings before interest and income tax is $30,000,000, this plan offers the lowest EPS ($2.40) on common stock. The principal advantage of Plan 3 is that little additional investment would need to be made by common shareholders for them to retain their current interest in the company. Also, it offers the largest EPS ($9.06) if earnings before interest and income tax is $30,000,000. Its principal disadvantage is that the bonds carry a fixed annual interest charge and require the payment of principal. It also requires a dividend payment to preferred stockholders before a common dividend can be paid. Finally, Plan 3 provides the lowest EPS ($0.03) if earnings before interest and income tax is $1,800,000. Plan 2 provides a middle ground in terms of the advantages and disadvantages described in the preceding paragraphs for Plans 1 and 3. 840 Prob. 15–2B 1. Cash ........................................................................... Premium on Bonds Payable ............................... Bonds Payable .................................................... 18,375,706* 2,375,706 16,000,000 *Present value of $1 for 14 (semiannual) periods at 5% (semiannual rate) ........................ 0.50507 Face amount ............................................................. × $16,000,000 Present value of an annuity of $1 for 14 periods at 5% ....................................................... 9.89864 Semiannual interest payment .................................. × $1,040,000 Proceeds of bond issue ........................................... 2. a. Interest Expense ................................................. Premium on Bonds Payable ($2,375,706/14) .... Cash ................................................................ 870,307 169,693 b. Interest Expense ................................................. Premium on Bonds Payable ............................... Cash ................................................................ 870,307 169,693 $ 8,081,120 10,294,586 $18,375,706 1,040,000 1,040,000 3. $870,307 4. Yes. Investors will be willing to pay more than the face amount of the bonds when the interest payments they will receive from the bonds exceed the amount of interest that they could receive from investing in other bonds. 841 Prob. 15–3B 1. Cash ........................................................................... Discount on Bonds Payable .................................... Bonds Payable .................................................... 20,344,863* 1,655,137 22,000,000 *Present value of $1 for 40 (semiannual) periods at 6% (semiannual rate) ........................ 0.09722 Face amount ............................................................. × $22,000,000 Present value of an annuity of $1 for 40 periods at 6% ....................................................... 15.04630 Semiannual interest payment .................................. × $1,210,000 2. a. Interest Expense ................................................. Discount on Bonds Payable ($1,655,137/40) ............................................... Cash ................................................................ 1,251,378 b. Interest Expense ................................................. Discount on Bonds Payable ......................... Cash ................................................................ 1,251,378 $ 2,138,840 18,206,023 $20,344,863 41,378 1,210,000 41,378 1,210,000 3. $1,251,378 4. Yes. Investors will not be willing to pay the face amount of the bonds when the interest payments they will receive from the bonds are less than the amount of interest that they could receive from investing in other bonds. 842 Prob. 15–4B 1. 2007 July Dec. 2008 June Dec. 2009 June 1 Cash .............................................................. Discount on Bonds Payable ........................ Bonds Payable ........................................ 11,252,273 747,727 31 Interest Expense .......................................... Cash ......................................................... 540,000 31 Interest Expense .......................................... Discount on Bonds Payable .................. 37,386 31 Income Summary ......................................... Interest Expense ..................................... 577,386 30 Interest Expense .......................................... Cash ......................................................... 540,000 31 Interest Expense .......................................... Cash ......................................................... 540,000 31 Interest Expense .......................................... Discount on Bonds Payable .................. 74,772 31 Income Summary ......................................... Interest Expense ..................................... 1,154,772 30 Bonds Payable ............................................. Loss on Redemption of Bonds ................... Discount on Bonds Payable .................. Cash ......................................................... 12,000,000 358,183 2. a. b. 3. Initial carrying amount of bonds .................................. Discount amortized on December 31, 2007................. Discount amortized on December 31, 2008................. Carrying amount of bonds, December 31, 2008.......... 12,000,000 540,000 37,386 577,386 540,000 540,000 74,772 1,154,772 598,183 11,760,000 2007: $577,386 2008: $1,154,772 843 $11,252,273 37,386 74,772 $11,364,431 Prob. 15–5B 2007 Sept. 1 Dec. 31 31 2013 June 30 Aug. 31 31 Investment in Ivan Company Bonds ................. Interest Revenue ($800,000 × 9% × 2/12) .......... Cash ................................................................. 853,100 12,000 Cash ($800,000 × 9% × 6/12) .............................. Interest Revenue ............................................. 36,000 Interest Revenue ................................................. Investment in Ivan Company Bonds ............. 1,800 Cash ..................................................................... Interest Revenue ............................................. 36,000 Interest Revenue ................................................. Investment in Ivan Company Bonds ............. 1,800 Cash ..................................................................... Gain on Sale of Investments .......................... Investment in Ivan Company Bonds ............. Interest Revenue ............................................. 865,100 36,000 1,800 36,000 1,800 413,500* 1,900 405,600 6,000 *($400,000 × 1.02) + ($400,000 × 9% × 2/12) – $500. Dec. 31 31 Cash ..................................................................... Interest Revenue ............................................. 18,000 Interest Revenue ................................................. Investment in Ivan Company Bonds ............. 2,700 844 18,000 2,700 Appendix Prob. 15–6B 1. a. Interest Expense ...................................................... Premium on Bonds Payable [$1,040,000 – (5% × $18,375,706)] ........................... Cash ..................................................................... 918,785 b. Interest Expense ...................................................... Premium on Bonds Payable [$1,040,000 – (5% × $18,254,491)] ........................... Cash ..................................................................... 912,725 121,215 1,040,000 127,275 1,040,000 2. $918,785 Appendix Prob. 15–7B 1. a. Interest Expense ...................................................... Discount on Bonds Payable [($20,344,863 × 6%) – $1,210,000] ...................... Cash ..................................................................... 1,220,692 b. Interest Expense ...................................................... Discount on Bonds Payable [($20,355,555 × 6%) – $1,210,000] ...................... Cash ..................................................................... 1,221,333 2. $1,220,692 845 10,692 1,210,000 11,333 1,210,000 COMPREHENSIVE PROBLEM 4 1. a. Cash .......................................................................... Common Stock ................................................... Paid-In Capital in Excess of Par— Common Stock ................................................... 812,500 b. Cash .......................................................................... Preferred Stock ................................................... Paid-In Capital in Excess of Par— Preferred Stock ................................................... 1,600,000 c. Cash .......................................................................... Bonds Payable .................................................... Premium on Bonds Payable .............................. 16,869,339 375,000 437,500 1,250,000 350,000 15,000,000 1,869,339 Computations: Present value of face amount of $15,000,000 compounded semiannually × 0.37689 [present value of $1 for 20 (semiannual) periods at 5% (semiannual rate)] .................................................... Present value of semiannual interest payments of $900,000 at 5% compounded semiannually: $900,000 × 12.46221 (present value of annuity of $1 for 20 periods at 5%) ................................. Total present value of bonds .................................. $ 5,653,350 11,215,989 $16,869,339 d. Cash Dividends ($0.25 × 125,000) + (2.5 × 18,750) Cash Dividends Payable .................................... 78,125 e. Cash Dividends Payable .......................................... Cash ..................................................................... 78,125 f. Bonds Payable ......................................................... Premium on Bonds Payable .................................... Cash ..................................................................... Gain on Redemption of Bonds .......................... 500,000 6,150 g. Treasury Stock ......................................................... Cash ..................................................................... 390,625 846 78,125 78,125 505,000 1,150 390,625 Comp. Prob. 4 Continued h. Stock Dividends ....................................................... Cash Dividends ........................................................ Stock Dividends Distributable ........................... Paid-In Capital in Excess of Par— Common Stock ................................................... Cash Dividends Payable .................................... 151,406* 46,875 71,250 80,156 46,875 *125,000 – 6,250 = 118,750 118,750 × 2% = 2,375 2,375 × $63.75 = $151,406 i. Stock Dividends Distributable ................................ Cash Dividends Payable .......................................... Common Stock ................................................... Cash ..................................................................... 71,250 46,875 j. Investment in Lewis Sports Inc. Bonds ................. Interest Revenue ...................................................... Cash ..................................................................... 145,500 5,625 k. Cash .......................................................................... Treasury Stock .................................................... Paid-In Capital from Sale of Treasury Stock .... 271,875 l. Interest Expense ...................................................... Premium on Bonds Payable .................................... Cash ..................................................................... 806,533 93,467 71,250 46,875 151,125 234,375 37,500 900,000 Computations: Semiannual interest payment ................................. Amortization premium [($1,869,339/120 months) × 6 months, rounded] ........................................ Interest expense ....................................................... m. Interest Receivable .................................................. Interest Revenue ................................................. Interest accrued for four months. $900,000 93,467 $806,533 7,500 7,500 Computation: $150,000 × 15% × 4/12 = $7,500 Investment in Lewis Sports Inc. Bonds ................. Interest Revenue ................................................. Amortization of discounts for four months. 847 120 120 Comp. Prob. 4 2. Continued a. DELHOME PRODUCTS INC. Income Statement For the Year Ended July 31, 2008 Sales ................................................................. Cost of merchandise sold .............................. Gross profit...................................................... Operating expenses: Selling expenses: Sales salaries expense ........................ Sales commissions .............................. Advertising expense............................. Depreciation expense—store buildings and equipment................................. Delivery expense .................................. Store supplies expense ....................... Miscellaneous selling expense ........... Administrative expenses: Office salaries expense ....................... Office rent expense .............................. Depreciation expense—office buildings and equipment................................. Office supplies expense ...................... Miscellaneous administrative expense Special charges: Restructuring charges ......................... Fixed asset impairment........................ Total expenses ........................................... Income from operations ................................. Other expenses and income: Interest revenue ......................................... Gain on redemption of bonds (net of applicable income tax of $150)............ Interest expense ........................................ Income from continuing operations before income tax .................................................. Income tax ....................................................... Income from continuing operations .............. Loss from disposal of a discontinued operations .................................................. Less applicable income tax ............................ Net income ....................................................... 848 $ 6,300,000 3,498,750 $ 2,801,250 $360,000 195,000 150,000 90,000 27,000 20,000 13,750 $855,750 $170,000 50,000 25,000 10,000 7,500 262,500 $ 93,750 187,500 281,250 1,399,500 $ 1,401,750 $ 2,025 1,000 (778,266) (775,241) $ $ 626,509 247,509 379,000 $ 150,000 229,000 $250,000 100,000 Comp. Prob. 4 Continued Earnings per common share: Income from continuing operations .................................. Loss on discontinued operations ...................................... Net income ........................................................................... $1.53* 1.20 $0.33 *($379,000 – $187,500 preferred dividends)/125,000 common shares. b. DELHOME PRODUCTS INC. Retained Earnings Statement For the Year Ended July 31, 2008 Retained earnings, August 1, 2007 ................ Net income for year ......................................... Less dividends: Cash dividends .......................................... Stock dividends ......................................... Decrease in retained earnings ....................... Retained earnings, July 31, 2008 ................... 849 $2,302,970 $229,000 $310,315 151,406 461,721 232,721 $2,070,249 Comp. Prob. 4 Continued c. DELHOME PRODUCTS INC. Balance Sheet July 31, 2008 Assets Current assets: Cash ......................................................... $ 250,000 Accounts receivable ............................... $ 562,500 Less allowance for doubtful accounts .. 43,750 518,750 Notes receivable ..................................... 156,250 Merchandise inventory, at lower of cost (fifo) or market ...................................... 850,000 Interest receivable .................................. 7,500 Prepaid expenses ................................... 31,250 Total current assets ............................. $ 1,813,750 Investments: Investment in Lewis Sports Inc. bonds 145,620 Property, plant, and equipment: Store buildings and equipment ............. $ 21,920,876 Less accumulated depreciation ............ 4,428,750 $17,492,126 Office buildings and equipment ............ $ 7,412,500 Less accumulated depreciation ............ 1,670,650 5,741,850 Total property, plant, and equipment . 23,233,976 Intangible assets: Goodwill................................................... 540,000 Total assets .................................................. $25,733,346 850 Comp. Prob. 4 Concluded Liabilities Current liabilities: Accounts payable ...................................... Employee termination obligation ............. Income tax payable .................................... Dividends payable ..................................... Deferred income tax payable .................... Total current liabilities ......................... Long-term liabilities: Bonds payable, 11%, due 2018 ................. Add premium on bonds payable .............. Deferred credits: Deferred income tax payable .................... Total liabilities ................................................. $ 212,000 81,250 40,000 37,500 17,500 $ 388,250 $14,500,000 1,769,722 16,269,722 33,875 $16,691,847 Stockholders’ Equity Paid-in capital: Preferred 8% stock, $125 par (30,000 shares authorized; 18,750 shares issued) ................................................... $ 2,343,750 Excess of issue price over par ................. 300,000 $ 2,643,750 Common stock, $30 par (400,000 shares authorized; 124,875 shares issued) .... $ 3,746,250 Excess of issue price over par ................. 700,000 4,446,250 From sale of treasury stock ...................... 37,500 Total paid-in capital .............................. $ 7,127,500 Retained earnings ........................................... 2,070,249 Total ............................................................ $ 9,197,749 Deduct treasury common stock (2,500 shares at cost) ........................................... 156,250 Total stockholders’ equity .............................. 9,041,499 Total liabilities and stockholders’ equity ...... $25,733,346 851 SPECIAL ACTIVITIES SA 15–1 GE Capital’s action was legal, but caused a great public relations stir at the time. Some quotes: “A lot of people feel like they have been sorely used,” said one bond fund manager. “There was nothing illegal about it, but it was nasty.” The fund manager said that GE Capital’s decision to upsize its bond issue to $11 billion from $6 billion midway through the offering ordinarily wouldn’t have upset bondholders. “But then to find out two days later that they had filed a $50 billion shelf?” he said. “People buy GE because it’s like buying Treasurys, not because they want to get jerked around.” GE Capital’s action was probably ethical, even though it caused some stir. In its own defense, it stated: In a statement released late Thursday, GE Capital said “with the $11 billion bond issuance of March 13, GE Capital exhausted its existing debt shelf registration; consequently, on March 20, GE Capital filed a $50 billion shelf registration.” The release said the shelf filing was not an offering and that it would be used in part to roll over $31 billion in maturing long-term debt. In retrospect, GE Capital could have been a little more forthcoming about its financing plans prior to selling the $11 billion on bonds, but there was nothing unethical or illegal about its disclosures. Source: “GE Capital Timing on $50B Shelf Filing Added To Backlash,” Dow Jones Capital Markets Report, March 22, 2002, Copyright (c) 2002, Dow Jones & Company, Inc. SA 15–2 Without the consent of the bondholders, Bob’s use of the sinking fund cash to temporarily alleviate the shortage of funds would violate the bond indenture contract and the trust of the bondholders. It would therefore be unprofessional. In addition, the use of Bob’s brother-in-law as trustee of the sinking fund is a potential conflict of interest that could be considered unprofessional. 852 SA 15–3 Receive $5,000,000 today: Present value of $5,000,000 today = $5,000,000 Receive $2,000,000 today, plus $600,000 per year for 10 years: Present value of $2,000,000 today = $2,000,000 Present value of annual payments = $600,000 × 6.41766 (Present value of an annuity of $1 for 10 periods at 9%) = $3,850,596 Total value = Present value of $2,000,000 + Present value of annual payments Total value = $2,000,000 + $3,850,596 = $5,850,596 Receive $1,000,000 per year for 10 years: Present value of annual payments = $1,000,000 × 6.41766 (Present value of an annuity of $1 for 10 periods at 9%) = $6,417,660 The option that has the highest value in terms of present value is to receive $1,000,000 per year for 10 years. SA 15–4 The primary advantage of issuing preferred stock rather than bonds is that the preferred stock does not obligate Beacon to pay dividends, while interest on bonds must be paid. That is, the issuance of bonds will require annual interest payments, thus necessitating a periodic (probably semiannual) cash outflow. Given St. Seniors volatility of operating cash flows, the required interest payments might strain Beacon’s liquidity. In the extreme, this could even lead to a bankruptcy of Beacon. The issuance of bonds has the advantage of providing a tax deduction for interest expense. This would tend to reduce the net (after-tax) cost of the bonds. Probably the safest alternative is for Beacon to issue preferred stock. Of course, another alternative might be to issue a combination of preferred stock and bonds. 853 SA 15–5 1. The following table lists the face value, coupon rate, and maturity of each bond issue. Face Value Coupon Rate Maturity Date $243 million 9.875% November 1, 2021 $250 million 9.625% March 15, 2022 $250 million 9.500% May 15, 2022 $240 million 9.125% July 1, 2022 $250 million 8.250% March 1, 2023 $250 million 8.125% June 15, 2023 2. Georgia-Pacific may have called these bond issues early for a number of reasons. These reasons might include refinancing at lower interest rates, using cash flows from operations to reduce leverage, refinancing debt with equity through an initial public offering (IPO) or a secondary offering, using the funds from the sale of a subsidiary to reduce leverage (as was the case with Georgia-Pacific in this example), or refinancing fixed rate debt with variable rate debt in anticipation of falling interest rates. SA 15–6 Note to Instructors: The purpose of this activity is to familiarize students with bonds as an investment and the sources of information about bonds. 854 SA 15–7 1. Plan 1 Plan 2 Shares of common stock .............................................. 160,000 247,500 Earnings before bond interest and income tax .......... $700,000 $700,000 Deduct interest on bonds ............................................. 350,000 227,500 Income before income tax ............................................ $350,000 $472,500 Deduct income tax ......................................................... 140,000 189,000 Net income ..................................................................... $210,000 $283,500 Earnings per share on common stock ........................ $ $ 1.31* 1.15** *210,000/160,000 **283,500/(160,000 + 87,500) 2. a. b. Factors to be considered in addition to earnings per share: 1. There is a definite legal obligation to pay interest on bonds, but there is no definite commitment to pay dividends on common stock. Therefore, if net income should drop substantially, bonds would be less desirable than common stock. 2. If the bonds are issued, there is a definite commitment to repay the principal in 20 years. In case of liquidation, the claims of the bondholders would rank ahead of the claims of the common stockholders. 3. Present stockholders must purchase the new stock if they are to retain their proportionate control and financial interest in the corporation. Since the net income has been relatively stable in the past and anticipated earnings under Plan 1 offer earnings per share of $1.31 for the common stockholder, Plan 1 appears to be somewhat more advantageous for present stockholders. SA 15–8 Note to Instructors: The purpose of this activity is to familiarize students with bond ratings and the importance of bond ratings to the issuer as well as to the investor. 855 SA 15–9 1. 2003: $22 2004: $1,703 2005: $1,975 2. 2003: 11,620.9 = ($255,638 + $22)/$22 2004: 183.2 = ($310,205 + $1,703)/$1,703 2005: 177.6 = ($348,798 + $1,975)/$1,975 While the company’s ratio decreased significantly between 2003 and 2004, this was due to the fact that the company had virtually no interest expense before 2004. The company’s current ratio of 177.6 times is still extremely favorable. 856
