4
The Balance Sheet (Continued):
Additional Financing – Borrowing
From Others
Discussion Questions
4-1. Economic factors such as inflation complicate the process of
lending money because interest rates (both what banks
charge and what they earn) rise and fall in response to
inflationary pressures in the economy. For example, assume
a bank has loaned money at a 5% interest rate for a fiveyear period. In order to earn a profit, the interest rate paid for
the money it has loaned must be lower than 5%. If, during
the term of the loan, inflation forces the bank to pay more
interest to its depositors (say 6%), the bank is actually losing
money on the funds it has loaned because it is paying 6%
but earning only 5%.
A debt-averse philosophy by business can also make
banks’ profits disappear as more businesses try to finance
their growth from internally-generated funds.
4-2. Loan defaults need to be minimized by thoughtful credit
policies for initially loaning the money, followed up by earlier
intervention by the bank when payments become delinquent.
Banks can offer rewards to depositors that keep their
deposits in the bank for a specified period of time (similar to
what the variation of “reward” in CD rates tries to
accomplish). Economic conditions such as inflation cannot
necessarily be overcome by the bank, but credit and
collection policies can be designed to plan for such
pressures.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-1
4-3. The $5,000 represents the lender’s return OF investment
and the interest payment of $100 represents the return ON
investment for the lender.
4-4. There is obviously no way we can anticipate the actual rates
your students will identify for various CDs. Rate differentials
are the way banks try and reward or encourage depositors to
leave larger sums, for longer times, on deposit with the bank.
4-5. There is obviously no way we can anticipate the actual
mortgage rates being charged in your area, or the current
credit card rates. In most instances, however, mortgage
rates will be lower than credit card rates. Two reasons for
the differences between mortgage rates and credit card
rates are: (1) the difference in time of repayment for the
credit card (short-term) versus the mortgage (long-term), and
(2) the difference in collateral (none with the credit card while
the real property usually secures the mortgage).
4-6. The business can only utilize $70,000 ($100,000 loan –
$30,000 compensating balance), but the business must pay
interest on the full $100,000 until the principal balance is
repaid or reduced. This alters the interest rate on the loan as
shown in the following example:
Loan amount
$100,000
Term
1 year
Interest rate
10%
Term Interest
$10,000
Effective Interest
No compensating balance $10,000/$100,000 = 10%
$30,000 compensating balance $10,000/ $70,000 = 14.29%
F4-2
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-7. The effective interest rate on the credit card is not 21%.
Consider the following:
Loan amount
$1,000 Savings Balance
$500
Term
1 year Term
l year
Interest rate
21%
Interest Rate
5%
Term Interest
$210 Term Interest
$25
Effective Interest $210/$500 – 25/$500 = $185/$500 = 37%
4-8. 1,000 bonds x $1,000 x .98 = $980,000
4-9. Cost of borrowing over the life of the bonds:
Received by the corporation
$ 980,000
Total payments made by the corporation
Principal
$1,000,000
Interest ($1,000,000 x 10% x 10 years)
1,000,000
$2,000,000
Total cost of borrowing
$1,020,000
Effective annual interest = $1,020,000/10 = 10.41%
$ 980,000
(This is an approximate annual interest rate on the bond. When calculated
on a financial calculator, the interest rate equals 10.33%.)
4-10. Cost of borrowing over the life of the bonds:
Received by the corporation
$1,030,000
Total payments made by the corporation
Principal
Interest ($1,000,000 x 10% x 10 years)
$1,000,000
1,000,000
$2,000,000
Total cost of borrowing
$ 970,000
Effective annual interest = $970,000 / 10 = 9.42%
$1,030,000
(This is an approximate annual interest rate on the bond. When calculated
on a financial calculator, the interest rate equals 9.52%.)
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-3
4-11. The purchase price of the bond is irrelevant as long as the
yield equals 10 percent. When the annual interest paid by the
corporation does not equal 10 percent of the par value of the
bond, the bond purchaser adjusts the initial purchase price such
that the overall yield on the bond equals 10%. If the bond pays
less than 10% cash interest, the purchaser will pay less than par
value (a discount) for the bond. If the bond pays more than 10%
cash interest, the purchaser will pay more than par value (a
premium) for the bond.
Review the Facts
A.
Internal financing provides funds for the operation of a
company through the earnings process of the company.
External financing is the acquisition of funds from outside the
company. Equity and debt financing are the two major types
of external financing.
B.
Equity (sale of stock) and debt financing are the two major
types of external financing.
C.
Consumer borrowing represents loans obtained by
individuals to buy homes, cars, and other personal property.
Commercial borrowing is the process that businesses go
through to obtain financing.
D.
The three major types of financial institutions that provide
financing in the U.S. today are savings and loans, credit
unions, and commercial banks.
E.
Interest is the cost to the borrower for the use of someone
else’s money. Interest is also what can be earned by
lending money to someone else.
F4-4
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F.
When a company borrows money the assets of the company
increase and the liabilities of the company increase.
G.
The formula for interest is as follows: I = P x R x T
P (amount borrowed) x R (interest rate) x T (period loan is
outstanding)
H.
Collateral is something of value that will be forfeited if
borrower fails to make payments as agreed which often
gives the borrower more favorable terms.
I.
A mortgage is a document that states the agreement
between a lender and a borrower who has secured the loan
by offering something of value as collateral. Usually a
mortgage specifying some specific item as collateral is for a
longer period of time than a promissory note which is simply
a written promise to repay.
J.
The use of bonds is sometimes necessary if a company
needs to borrow larger sums of money than the bank is
willing to loan or if the company needs the borrowed funds
for a longer period of time than a bank is willing to commit.
K.
Par value (bonds) is the amount that must be paid back
upon maturity of a bond. The par value is also called face
value or maturity value. The stated rate on a bond is the
interest rate set by the issuers of the bonds, stated as a
percentage of the par value of the bonds. The stated rate is
also called the nominal interest rate, the contract rate, or the
coupon rate of interest.
L.
The nominal rate of interest is the rate stated on the bond
and represents the cash interest to be paid. The market rate
of interest represents the rate of interest in the market place
at a given time.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-5
M.
The selling price of a bond is the amount received when
bonds are issued or sold. This amount is affected by the
difference between the nominal interest rate and the market
rate. Selling price is usually stated as a percentage of the
bonds par value. This is also called the market price.
N.
The primary function of the underwriters is to get the
issuance of bonds or stocks sold to the public.
O.
The selling price of a bond is determined by many factors. A
primary factor in the determination of the selling price of a
bond is the market rate of interest. If the market rate of
interest is below the stated rate then the bond will sell at a
premium and if the market rate of interest is above the stated
rate of interest then the bond will sell at a discount.
P.
As it is with stock, the original issue of the bonds takes place
in the primary market. The continued trading of the bonds by
the bondholders takes place in the secondary market.
Q.
The effective interest rate can be found by rearranging the
original formula that stated: I = P x R (assuming a yearly
rate). By solving for R (rate) one can determine the effective
interest rate. The formula would be stated as R = I / P.
R.
Investors often make the investment decisions base on how
they feel about the tradeoff between risk and reward. Often
the major question asked by prospective investors is “Will I
be paid?”
F4-6
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
Apply What You Have Learned
4-12.
a. The bank loans money to the purchaser of the car to pay the
car dealer. The bank charges the purchaser of the car (the
borrower) interest for the time period that he or she borrows
the money. The purchaser makes installment payments
consisting of interest and partial repayment of the principal.
The interest paid by the borrower becomes part of the gross
revenue of the bank. If the bank’s gross revenue is greater
than all its operating expenses, the bank earns a profit.
b. Consumer lending is the process of lending to the ultimate
user of a product; consumer borrowing is the process of an
individual borrowing for a personal use acquisition. A car
loan made to an individual for the purchase of a personal
use automobile, purchases made with a credit card, or a
washing machine purchased on a finance plan are examples
of consumer borrowing.
Commercial lending and borrowing refers to the lending
and borrowing process between the lender and a business
entity for the purpose of conducting business. Examples are
commercial financing of business equipment, merchandise
inventory, or working capital. Banks and other lenders also
lend for long-term projects such as commercial office
buildings, apartments and other leased real estate, and
manufacturing plants.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-7
4-13.
Savings and Loan Associations (S&Ls) and Mutual Savings
Banks (MSBs) were formed primarily to lend money for home
mortgages. Over time Savings and Loans began lending money
for other smaller consumer items. Mutual Savings Banks are
owned by the depositors and any profits are divided
proportionately among the depositors. Both the S&Ls and the
MSBs began as consumer lending institutions, but over time,
broadened the focus into other ventures. In the 1980's many of
the S&Ls and the MSBs experienced financial difficulties.
A company, labor union, or professional group typically
forms a credit union (CU). A credit union accepts deposits from
and lends money to its members exclusively. To become a credit
union member, a person must meet specific qualifications, such
as working for a particular employer, or belonging to the founding
organization. Traditionally, CUs have concentrated on short-term
consumer loans and savings deposits for their members. In recent
years most CUs have added checking services, but their main
focus remains with short-term consumer type loans.
Commercial Banks are heavily involved in commercial
lending. In fact, while banks have ventured into the area of
consumer lending, these institutions primarily lend to businesses.
4-14.
a. ($15,000 x 80%) x 9% = $1,080 Interest in Year 1
b. ($12,000 – $2,000) x 9% = $900 Interest in Year 2
4-15.
a. ($20,000 x 70%) x 10% = $1,400 Interest in Year 1
b. ($14,000 – $3,000) x 10% = $1,100 Interest in Year 2
4-16.
a. ($10,000 x 75%) x 12% = $900 Interest in Year 1
b. ($7,500 – $2,000) x 12% = $660 Interest in Year 2
c. ($2,000) x 12% = $240 Interest Savings in Year 2
F4-8
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-17.
a.
F&E ENTERPRISES, INC.
Balance Sheet
January 3, 2007
Assets
Cash
Total Assets
Liabilities and Stockholders’ Equity
$50,000 Liabilities:
Notes Payable
$20,000
Stockholders’ Equity:
Common Stock
$15,000
Additional Paid-in
Capital
15,000
Total Stockholders’ Equity
30,000
Total Liabilities and
$50,000
Stockholders’ Equity
$50,000
b.
$20,000 x 8% x 12/12 = $1,600 Interest
c.
The bank is to be paid one year later on January 3, 2008,
and they are to receive $21,600 which is the total of the
principal and the interest. The return of investment is
$20,000 and the return on investment is $1,600.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-9
4-18.
a.
F&E ENTERPRISES, INC.
Balance Sheet
January 3, 2007
Assets
Cash
Total Assets
b.
c.
d.
F4-10
Liabilities and Stockholders’ Equity
$50,000 Liabilities:
Notes Payable
$20,000
Stockholders’ Equity:
Common Stock
$15,000
Additional Paid-in
Capital
15,000
Total Stockholders’ Equity
30,000
Total Liabilities and
$50,000
Stockholders’ Equity
$50,000
$20,000 x 8% x 3/12 = $400 Interest
Due date is April 3.
Calculation: January (31 – 3 days)
28
February
28
March
31
April (due date)
3
Total Days
90
By coincidence, the three-month period from January 3 to
April 3 equals 90 days. If the bank uses 365 days as its
basis for interest calculation, the interest due on a 90-day
note on April 3, 2007, would be $394.52.
$20,000 x 8% x 90/365 = $394.52
If the banks uses a 360 day basis to calculate interest, the
interest due would be $400.
The bank is to be paid on April 3, 2007 and they will be
$20,400. This includes the principal and the interest. The
return of investment is $20,000 and the return on investment
is $400.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-19.
a.
F&E ENTERPRISES, INC.
Balance Sheet
January 3, 2007
Liabilities and Stockholders’ Equity
Liabilities:
Bonds Payable
$100,000
Stockholders’ Equity:
Common Stock
$15,000
Additional Paid-in
Capital
15,000
Total Stockholders’ Equity
30,000
Total
Total Liabilities and
Assets $130,000
Stockholders’ Equity
$130,000
b. $100,000 x 10% x 6/12 = $5,000 semi-annual interest
c. $100,000 x 0.98 = $98,000
d. $100,000 x 1.03 = $103,000
Assets
Cash
$130,000
4-20.
1. f
2. g
3. c
4. h
5. j
6.
7.
8.
a
e
i
9.
b
10. d
The amount above par for which a bond is sold.
The amount of funds actually borrowed.
The rate of interest actually earned by a bondholder.
Failing to repay a loan as agreed.
Liabilities that allow corporations to borrow large amounts of
money for long periods of time.
The cost of using someone else’s money.
The amount below par for which a bond is sold.
An agreement between a lender (usually a bank) and
borrower that creates a liability for the borrower.
The interest rate set by the issuers of bonds, stated as a
percentage of the par value of the bonds.
The amount that is payable at the end of a borrowing
arrangement.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-11
4-21.
Bonds are used for long-term financing, usually from five to
forty years. Bonds also allow a company to borrow much larger
sums than they could acquire by borrowing from a single bank on
a note. Notes are used as a financing option when the money is
needed for a relatively shorter period of time (usually one to five
years) and the dollar amount needed is within the lending
capacity of the bank.
4-22.
1. b
2. a
3. b
4. b
5. b
6. a
7. b
8. a
Nominal interest rate
Effective interest rate
Stated interest rate
Coupon rate
The interest rate printed on the actual bond
Market interest rate
Contract rate
Yield rate
4-23.
Miller would rather issue bonds than borrow money at the
bank because the company should be able to borrow more
money, for a longer time, at a lesser interest rate by issuing bonds
than by borrowing from one bank. Most banks are unwilling to risk
such a large amount of depositors’ money on one commercial
loan. Banks cannot commit depositors’ money for 20 to 40 years
because most depositors will withdraw their funds within a very
short time.
F4-12
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-24.
a. Due date is June 1.
Calculation: March (31– 3 days)
April
May
June (due date)
Total Days
b.
c.
d.
28
30
31
1
90
Due date is July 19.
Calculation: April (30 – 20 days)
May
June
July (due date)
Total Days
10
31
30
19
90
Due date is October 17.
Calculation: July (31 – 19 days)
August
September
October (due date)
Total Days
12
31
30
17
90
Due date is January 3.
Calculation: October (31 – 5 days)
November
December
January (due date)
Total Days
26
30
31
3
90
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-13
4-25.
a. Due date is
Calculation: March (31– 7 days)
April
May
June
July (due date)
Total Days
b.
c.
d.
F4-14
Due date is August 17.
Calculation: April (30 – 19 days)
May
June
July
August (due date)
Total Days
24
30
31
30
5
120
11
31
30
31
17
120
Due date is September 2.
Calculation: May (3 – 5 days)
June
July
August
September (due date)
Total Days
26
30
31
31
2
120
Due date is December 8.
Calculation: August (31 – 10 days)
September
October
November
December (due date)
Total Days
21
30
31
30
8
120
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-26.
a. Due date is June 2.
Calculation: April (30 – 3 days) 27
May
31
June (due date)
2
Total Days
60
b.
Due date is July 18
Calculation: May (31 – 19 days)
June
July (due date)
Total Days
12
30
18
60
c.
Due date is August 4.
Calculation: June (30 – 5 days) 25
July
31
August (due date)
4
Total Days
60
d.
Due date is September 8.
Calculation: July (31 – 10 days)
August
September (due date)
Total Days
21
31
8
60
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-15
4-27.
a. Due date is August 23.
Calculation: April (30 – 25 days)
May
June
July
August (due date)
Total Days
b.
c.
Based on the principle of discounting a loan, the bank
deducts its interest in advance and then collects the full
amount of the loan, which in this case is $20,000.
Interest on the loan is calculated by the formula P x R x T.
In this question, neither the amount of the proceeds nor the
interest rate is provided. Therefore, we cannot calculate the
effective interest rate.
4-28.
a. Due date is August 23.
Calculation: April (30 – 25 days)
May
June
July
August (due date)
Total Days
b.
c.
d.
F4-16
5
31
30
31
23
120
5
31
30
31
23
120
Principal x Rate x
Time = Interest
$20,000 x 10% x (120 / 365) = $657.53
Proceeds: $20,000 – $657.53 = $19,342.47
The bank will receive the total of $20,000 on August 23.
Effective Interest = Interest x 365
Principal Days
= $657.53 x 365
$19,342.47
120
= 10.34%
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-29.
a. Due date is August 3.
Calculation: May (31 – 5 days)
June
July
August (due date)
Total Days
26
30
31
3
90
b.
Principal x Rate x Time = Interest
$50,000 x 8% x (90/365) = $986.30
Proceeds: $50,000 – $986.30 = $49,013.70
c. The bank will receive the total of $50,000 on August 3.
a. Effective Interest = Interest x 365
Principal Days
= $986.30 x 365
$49,013.70
90
= 8.16%
4-30.
a. Due date is September 15
Calculation: March (31 – 19 days)
April
May
June
July
August
September (due date)
Total Days
b.
c.
d.
12
30
31
30
31
31
15
180
Principal x Rate x Time = Interest
$10,000 x 12% x (180/365) = $591.78
Proceeds: $10,000 – $591.78 = $9,408.22
The bank will receive the total of $10,000 on September 15.
Effective Interest = Interest x 365
Principal
Days
= $591.78 x 365
$9,408.22
180
= 12.75%
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-17
4-31.
a. Cash received by issuing company:
[6,500 bonds x $1,000 x 96%] = $6,240,000.
b. Interest received by bondholders each year:
[ $1,000 x 8% x 6,500 bonds] = $520,000.
c. Return on Investment:
$1,000 x .08 x 5 years
$400
$1,000 maturity value – $960 cost
40
Total return on investment per bond
$440
Return of Investment: $960.
The amount of the original investment is returned when the
bond matures. Actually, $1,000 is returned at that time. The
extra $40 is accounted for as an additional part of the return
on investment as shown above.
d. The market rate of interest is greater than the coupon rate of
8%. We can determine this from the fact the bonds sold for
less than the par value of $1,000.
4-32.
a. Cash received by issuing company:
[2,500 bonds x $1,000 x 103%] = $2,575,000
b. Interest received by bondholder each year:
[ $1,000 x 12% x 2,500 bonds] = $300,000
c. Return on Investment:
$1,000 x .12 x 5 years
$600
$1,000 maturity value – $1,030 cost
< 30>
Total return on investment per bond
$570
Return of Investment: $1,030.
The amount of the original investment is returned when the
bond matures. Actually, only $1,000 is returned at that time.
The extra $30 invested is deducted from the return on
investment, as shown above.
d. The market rate of interest is less than the coupon rate of
12%. We can determine this from the fact the bonds sold for
more than the par value of $1,000.
F4-18
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-33.
a. Cash received each year by the investor:
[$1,000 x 9%] = $90
b. Return on Investment:
$1,000 x .09 x 5 years
$450
$1,000 maturity value – $950 cost
50
Total return on investment
$500
Return of Investment: $950.
The amount of the original investment is returned when the
bond matures. Actually, $1,000 is returned at that time. The
extra $50 is accounted for as an additional part of the return
on investment, as shown above.
c. The market rate of interest is greater than the coupon rate of
9%. We can determine this from the fact the bond sold for
less than its par value of $1,000.
4-34.
a. Cash received each year by the investor:
[$1,000 x 8%] = $80
b. Return on Investment:
$1,000 x .08 x 5 years
$400
$1,000 maturity value – $1,040 cost
< 40>
Total return on investment
$360
Return of Investment: $1,040.
The amount of the original investment is returned when the
bond matures. Actually $1,000 is returned at that time. The
extra $40 invested is deducted from the return on the
investment, as shown above.
c. The market rate of interest is less than the coupon rate of
8%. We can determine this from the fact the bond sold for
more than its par value of $1,000.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-19
4-35.
Using a 365-day basis to compute the interest, the answers are:
a. Principal x Rate x Time = Interest
$10,000 x 10% x (183/365) = $501.37
Alto must repay principal and interest that total $10,501.37.
b. ABC Bank will earn $501.37 in interest income.
c. Principal x Rate x Time = Interest
$10,000 x 10% x (91/365) = $249.32
ABC Bank will earn $249.32 in interest income.
Using a whole-month basis to compute the interest, the answers
are:
a. Principal x Rate x Time = Interest
$10,000 x 10% x 6/12 = $500
Alto must pay back principal and interest that total $10,500.
b. ABC Bank will earn $500 in interest income.
c. Principal x Rate x Time = Interest
$10,000 x 10% x 3/12 = $250
ABC Bank will earn $250 in interest income.
F4-20
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-36.
Using a 365-day basis to compute the interest, the answers are:
a. Principal x Rate x Time = Interest
$20,000 x 12% x (363/365) = $2,386.85
Principal + Interest = $20,000.00 + $2,386.85 = $22,386.85
b. Principal x Rate x Time = Interest
$20,000 x 10% x (363/365) = $1,989.04
Principal + Interest = $20,000.00 + $1,989.04 = $21,989.04
c. Principal x Rate x Time = Interest
$20,000 x 12% x (274/365) = $1,801.64
Principal + Interest = $20,000.00 + $1,801.64 = $21,801.64
d. Principal x Rate x Time = Interest
$20,000 x 9% x (121/365) = $596.71
Principal + Interest = $20,000.00 + $596.71 = $20,596.71
Using a whole-month basis to compute the interest, the answers
are:
a. Principal x Rate x Time = Interest
$20,000 x 12% x 12/12 = $2,400
Principal + Interest = $20,000 + $2,400 = $22,400
b. Principal x Rate x Time = Interest
$20,000 x 10% x 12/12 = $2,000
Principal + Interest = $20,000 + $2,000 = $22,000
c. Principal x Rate x Time = Interest
$20,000 x 12% x 9/12 = $1,800
Principal + Interest = $20,000 + $1,800 = $21,800
d. Principal x Rate x Time = Interest
$20,000 x 9% x 4/12 = $600
Principal + Interest = $20,000 + $600 = $20,600
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-21
4-37.
Using a 365-day basis to compute the interest, the answers are:
a. Principal x Rate x Time = Interest
$100,000 x 6% x (363/365) = $5,967.12
b. Principal x Rate x Time = Interest
$100,000 x 8% x (363/365) = $7,956.16
c. Principal x Rate x Time = Interest
$100,000 x 6% x (274/365) = $4,504.11
d. Principal x Rate x Time = Interest
$100,000 x 8% x (121/365) = $2,652.05
Using a whole-month basis to compute the interest, the answers
are:
a. Principal x Rate x Time = Interest
$100,000 x 6% x 12/12 = $6,000
b. Principal x Rate x Time = Interest
$100,000 x 8% x 12/12 = $8,000
c. Principal x Rate x Time = Interest
$100,000 x 6% x 9/12 = $4,500
d. Principal x Rate x Time = Interest
$100,000 x 8% x 4/12 = $2,667
4-38.
Underwriters assist corporations in completing all the
necessary steps for successful sales of stocks and bonds. One of
the most important steps coordinated by the underwriters is the
preparation of the prospectus. This document provides important
information to prospective purchasers of the stocks or bonds,
including information about the issuing corporation. One of the
biggest benefits of using the underwriter is that most corporations
are not equipped to handle the intricacies of stock or bond
issuances in the primary markets. Underwriters are important to
the financial markets because they enable corporations to raise
large amounts of capital.
F4-22
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-39.
1. e
Difference between the price paid to the issuer and the
price at which securities are sold to the public.
2.
a
A group of underwriters working together to get a large
bond issue sold to the public.
3.
b
A description of a bond issue that provides information
to potential investors.
4.
c
Bond selling price is below its par value.
5.
d
Bond selling price is above par value.
6.
f
A global underwriter.
4-40.
The nominal rate of interest is the specified annual cash
interest paid on a bond, and is a percentage of the par value of
the bond. It is the rate of interest the issuing company agreed to
pay and is shown on the face of each bond certificate. In contrast
to the nominal interest rate is the market rate, which is determined
when the bonds are sold. The effective or market rate of interest
fluctuates with market conditions. The effective or market rate of
interest is determined by investors in the financial markets and
may cause a bond to sell for more or less than its par value.
The selling price of the bond is the amount for which a bond
actually sells. If the effective rate and the nominal rate are the
same at the time of issuance, a bond sells at par value. If the
market rate required by investors rises, the bonds will sell for less
than they would have if the market rate remained the same. If the
market rate is higher than the nominal rate, the bonds sell at a
discount (less than par) because the nominal rate is constant and
does not change with market interest rate changes.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-23
4-41.
The nominal rate of interest is the specified annual interest
paid on a bond and is a percentage of the par value of the bond.
It is the rate of interest the issuing company agreed to pay and is
shown on the face of each bond certificate. In contrast to the
nominal interest rate is the market rate which is determined when
the bonds are sold. The effective or market rate of interest
fluctuates with market conditions. The effective or market rate of
interest is determined by investors in the financial markets and
may cause a bond to sell for more or less than its par value.
The selling price of the bond is the amount for which a bond
actually sells. If the effective rate and the nominal rate are the
same at the time of issuance, a bond sells at par value. If the
market rate required by investors declines, the bonds will sell for
more than they would have if the market rates remained the
same. If the market rate decreases below the nominal rate, the
bonds should sell for a premium (greater than par), because the
nominal rate is constant and does not change with market interest
rate fluctuations.
4-42.
a. Because the market rate of interest required by investors is
greater than the coupon rate, we would expect the bonds to
sell at a discount. Investors, who desire a higher rate of
interest for the level of risk that King Corporation is offering,
will not be willing to purchase the bonds at par. The
difference in the purchase price will cause the investors to
yield their desired rate of return.
b. When the corporation issues the bonds to the first buyer, the
sale occurs in the primary bond market. Sometimes the first
sale is to an intermediary, who subsequently resells them in
the secondary market.
F4-24
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-43.
a. Because the market rate of interest required by investors is
less than the coupon rate, we would expect the bonds to sell
at a premium. Investors, who require a lower rate of interest
for the level of risk that Tamara Corporation is offering, will
be willing to pay more than par for the bonds to receive the
higher cash interest payments. The difference in the
purchase price will cause the investors to yield their original
desired rate of return.
b. When the corporation issues the bonds to the first buyer, the
sale occurs in the primary bond market. Sometimes the first
sale is to an intermediary, who subsequently resells them in
the secondary market.
4-44.
a. Because the market rate of interest is the same as the
coupon rate, we would expect the bonds to sell at par
because investors will receive the yield they desire for the
corporation’s level of risk.
b. When the corporation issues the bonds to the first buyer, the
sale occurs in the primary bond market. Sometimes the first
sale is to an intermediary, who subsequently resells them in
the secondary market.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-25
4-45.
a.
BENNETT ENGINES, INC.
Balance Sheet
January 2, 2007
Liabilities and Stockholders’ Equity
Liabilities:
$ -0Stockholders’ Equity:
Common Stock
$ 1,200
Additional Paid-in
Capital
22,800
Total Stockholders’ Equity
24,000
Total
Total Liabilities and
Assets $24,000
Stockholders’ Equity
$24,000
Assets
Cash
$24,000
b.
BENNETT ENGINES, INC.
Balance Sheet
January 3,2007
Liabilities and Stockholders’ Equity
Liabilities:
Notes Payable
$12,000
Stockholders’ Equity:
Common Stock
$ 1,200
Additional Paid-in
Capital
22,800
Total Stockholders’ Equity
24,000
Total
Total Liabilities and
Assets $36,000
Stockholders’ Equity
$36,000
Assets
Cash
$36,000
c.
Principal x Rate x Time = Interest
$12,000 x 9% x (365/365) = $1,080
d.
Principal x Rate x Time = Interest
$12,000 x 9% x (181/365) = $535.56
F4-26
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-46.
a.
STOWERS PUBLIC RELATIONS, INC.
Balance Sheet
January 2, 2007
Liabilities and Stockholders’ Equity
Liabilities:
$ -0Stockholders’ Equity:
Common Stock
$15,000
Additional Paid-in
Capital
15,000
Total Stockholders’ Equity
30,000
Total
Total Liabilities and
Assets $30,000
Stockholders’ Equity
$30,000
Assets
Cash
$30,000
b.
STOWERS PUBLIC RELATIONS, INC.
Balance Sheet
January 3, 2007
Liabilities and Stockholders’ Equity
Liabilities:
Bonds Payable
$100,000
Stockholders’ Equity:
Common Stock
$15,000
Additional Paid-in
Capital
15,000
Total Stockholders’ Equity
30,000
Total
Total Liabilities and
Assets $130,000
Stockholders’ Equity
$130,000
Assets
Cash
$130,000
c.
Principal x Rate x Time = Interest
$100,000 x 9% x 12/12 = $9,000
d.
e.
$1,000 x 100 bonds x .99 = $99,000
$1,000 x 100 bonds x 1.05 = $105,000
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-27
4-47.
GLORIA’S CORPORATION
Balance Sheet
January 2, 2009
Liabilities and Stockholders’ Equity
Liabilities:
Bonds Payable
$300,000
Stockholders’ Equity:
Common Stock
200,000
Total
Total Liabilities and
Assets $500,000
Stockholders’ Equity
$500,000
Assets
Cash
$500,000
4-48.
a. Both issuing bonds and issuing shares of common stock
allow a corporation to raise significant amounts of capital.
The two main reasons a corporation would prefer to issue
bonds rather than sell shares of common stock are the fixed
costs associated with the bonds, and retention of
management control.
Fixed Costs - Bonds carry a specific interest cost and
maturity value. If the interest rate is 8%, that is what the
corporation must pay. Even if the company becomes highly
profitable, it still is required to pay only the 8% interest
annually, and the principal at maturity. As profits rise,
stockholders tend to pressure the company to increase
dividends.
Management Control - The owners of common stock have
voting rights in important matters concerning how the
corporation conducts its business. The bond owners have no
voting rights and therefore no say in how the company is
run. By selling bonds rather than shares of common stock,
the company’s management can raise significant amounts of
capital without giving up operating control of the business.
F4-28
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-48. (Continued)
b. An investor would prefer to purchase shares of a company’s
common stock rather than a company’s bonds because of
potential appreciation in market value and voting rights.
Potential Appreciation - Bonds are a relatively less risky
investment than common stock, but the amount of return on
investment is limited to the agreed upon interest rate paid on
the bonds. The potential appreciation in market value of a
common stock investment is theoretically unlimited. If the
company is very profitable, the dividends on the common
stock will very likely increase and the price of the stock in the
secondary market will appreciate.
Voting Rights - Common stock is voting stock. The owner of
each share of common stock owns an equal share of the
corporation and has an equal vote in important matters
concerning how the corporation conducts its business.
4-49.
The nominal rate of interest is the annual cash interest paid
on a bond and is a percentage of the bond’s par value. It is the
rate of interest the issuing company agreed to pay and is shown
on the face of each bond certificate. In contrast to the nominal
interest rate, which is set before the bonds are issued and
remains constant, the effective or market rate of interest
fluctuates with market conditions. The effective or market rate of
interest is determined by investors in the financial markets.
The selling price of the bond is the amount for which a bond
actually sells. If the effective rate and the nominal rate are the
same at the time of issuance, a bond sells at par value. If
investors require a higher rate for a given level of risk than the
nominal rate, then the bonds will sell for a discount because the
nominal rate will not vary with market interest fluctuations. If the
rate required by investors is less than the nominal rate, then the
bonds will sell for a premium because the investors will pay more
than par to obtain the higher cash interest.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-29
4-50.
a. Ed can acquire 20, $1,000 bonds at a cost of $19,600.
b. Principal x Rate x Time = Interest
$20,000 x 8% x 12 / 12 = $1,600 per year in interest
c. Return on Investment:
$20,000 x .08 x 5 years
$8,000
$20,000 maturity value – $19,600 cost
400
Total return on investment
$8,400
Return of Investment: $19,600.
The amount of the original investment is returned when the
bond matures. Actually $20,000 is returned at that time. The
extra $400 is accounted for as an additional part of the
return on investment, as shown above.
d. Ed can purchase 1,000 shares of stock at a cost of $20,000.
e. $.80 x 1,000 shares = $800 each year in dividends
f.
$800 / $20,000 = 4%
4-51.
a. Joshua can acquire 48, $1,000 bonds at a cost of $49,440.
b. Principal x Rate x Time = Interest
$48,000 x 12% x 12/12 = $5,760 each year in interest
c. Return on Investment:
$48,000 x .12 x 5 years
$28,800
$48,000 maturity value – $49,440 cost
<1,440>
Total return on investment
$27,360
Return of Investment: $49,440.
The amount of the original investment is returned when the
bond matures. Actually $48,000 is returned at that time. The
extra $1,440 is accounted for as a reduction of the return on
investment as shown above.
d. Joshua can buy 666 shares of stock at a cost of $49,950.
e. $2.00 x 666 shares = $1,332 each year in dividends
f.
$1,332 / $49,950 = 2.67%
F4-30
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-52.
a. A debenture bond is a bond that is not secured by collateral
other than the full faith and credit of the issuing company.
b. The balance sheet value of the Southwest Airlines bonds
represents the book value of the bonds (selling price
adjusted for a premium or discount) and indicates that the
bonds originally sold at par. The $105,660,000 market value
of the Southwest Airlines bonds represents the bonds’
current trading value that is influenced by investors’ interest
rate demands. Because the bonds are selling above par
value, the market interest rate is lower than the stated rate.
c. The students’ answers will vary depending on the article
selected. It is important for the student to express their
reaction to what they read.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-31
4-53.
a. The term fiscal years relates to the operating year that ends
in any month but December. A fiscal year is a twelve-month
period that begins at a time other than January 1.
b. The main reason Clorox includes this information is that the
FASB requires this disclosure for long-term debt. With
current liabilities, the financial statement user knows when
the settlement is required – within one year. Without this
disclosure, the only prediction the user can make about longterm debt is that it becomes due more than one year from
the balance sheet date.
c. The schedule of required payments for long-term debt is
important to financial statement users because it helps them
predict the timing of future cash outflows. This information
may help decision makers understand the future cash flow
limitations that may be placed on the organization’s ability to
expand or to engage in other potential investments.
d. You would probably prefer to set the loan due in fiscal 2005
or fiscal 2006 based on the fact that the long-term debt
payments are lowest in these years.
e. The students’ answers will vary depending on the article
selected. It is important for the student to express their
reaction to what they read.
F4-32
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
4-54.
a. Total Assets = Total Liabilities + Total Stockholders’ Equity
$1,275,619,000 = $184,918,000+ $1,090,701,000
b. Claire’s sells inexpensive personal accessories in malls
throughout the United States and internationally. This type of
business would typically turn over its merchandise many
times during the year. Lenders might typically loan money on
merchandise for a short-term period and expect repayment
within the short-term. The company may also lease all of its
stores using operating leases, thereby not requiring longterm borrowing for buildings. The profitability of the stores
may enable them to self-finance the low level of fixture
purchases required for each store. The store sizes are
relatively small.
c. At this point in the book, students will have different levels of
comfort at rating an investment. They might mention the
following points:
1. From 1997 to 2006, its stores grew from 1,560 to the
point where the bulk of the growth now takes place
internationally. There are close to 800 stores now in
Europe, stores in Africa and the Middle East..
2. From 1997 to 2006, its net sales grew from $440million
to $1.37 billion.
3. Its return on average equity has remained over 20%
4. Its return on sales grew from 11.2% to 19%, from FYE
2005 to FYE 2006.
5. The company has little debt (20%) and high equity
(80%) and cash represents 39.5% of its assets. All of
these indicate a fairly safe investment.
d. The students’ answers will vary depending on the article
selected. It is important for the student to express their
reaction to what they read.
Chapter 4 – The Balance Sheet (Continued): Additional Financing – Borrowing from Others
F4-33