302385 Flashcards
Cumin Partners Inc. issues $150,000 of 12% bonds dated February 1, Year 1. Interest is payable quarterly on April 30, July 31, November 30, and January 31. The bonds mature in 6 years. The current market for similar bonds is 10%. The entire issue is sold on the date of issue. The following values are given:
Present Value of
Ordinary Annuity Present Value of $1 N=12; i=.05 8.86325 0.55684 N=12; i=.06 8.38384 0.49697 N=24; i=.02.5 17.88499 0.55288 N=24; i=.03 16.93554 0.49193 What amount of proceeds on the sale of bonds should Cumin report?
$163,295
$149,244
$163,414
$159,142
$163,414
This question is about the computation of the issue price for a bond. The bonds will pay quarterly, and thus will pay $4,500 four times each year, computed as follows:
Face amount of $150,000 × 12% coupon × 3/12 (fourth of a year) = $4,500
The yield of the bonds is 10% annually, but in quarterly periods it is 2.5% a quarter. The present value of the bonds is thus the $4,500 multiplied by the present value of the ordinary annuity for 24 periods and 2.5%, plus the $150,000 par value of the bonds multiplied by the present value of $1 at 24 periods, 2.5%:
Issue price = ($4,500 × 17.88499) + ($150,000 × 0.55288) = $80,482 + $82,932 = $163,414
Bond
A bond is a type of debt instrument or debt security in the name of the issuing party (a government or corporation) usually issued in denominations of $1,000. It is a legal document representing a long-term obligation to pay interest at a specified rate at specified intervals and to repay a specified amount (the principal) on a specified future date (at maturity). A bond represents a liability or debt to the issuer and is senior to (paid before) capital stock. A bond carries less risk than capital stock. The holder is the creditor, and the maker or issuer is the borrower or debtor. A bond is usually negotiable and can be sold or transferred, with the transferee becoming the holder in due course.
Bonds are classified in the following ways:
Character of the issuer: Federal, municipal (the interest received from which is tax-exempt), or corporate (industrial)
Character of the security: Secured, unsecured (debenture), or guaranty
Payment of interest: Ordinary, income, participating, registered, bearer, or coupon
Maturity of principal: Ordinary, callable, redeemable, convertible, or serial
In the United States, new corporate bond issues must be registered for tax reporting purposes, so bearer or coupon bonds are no longer issued by U.S. corporations.
Ordinary Annuity
An ordinary annuity is an annuity that is payable at the end of each period. An annuity due is payable at the beginning of each period. It is important to distinguish between the two when calculating present (or future) values.
Present Value
Present value is one of the attributes used to measure assets and liabilities. Present value is the present, or discounted (at the implicit or historical rate), value of future cash flows used for long-term receivables and payables.
2282.01
Computation of Issue Price
When a bond is issued, the bond contract (indenture) specifies the amount and timing of payments the issuer is obligated to pay. The issuer will pay the following:
The face or principal amount at the maturity date of the bonds
Interest at specified intervals, usually semi-annually, during the life of the bond based on a stated percentage of the face amount
The interest rate stated in the bond contract is known variously as the stated, coupon, contract, or nominal rate.
2282.02
The effective interest the issuer will pay is determined in the marketplace, not in the bond contract. At any given time, a market rate of interest exists. This is the rate that the investor (purchaser of a bond) can command in the marketplace for the particular type of bond and risk level. Accordingly, the investor is not willing to accept a return on the investment that is less than the market rate. Alternatively, the market rate of interest can be viewed as the rate that the issuer of the bonds can command in the marketplace. The issuer is not willing to pay any more for the use of the investor’s money than the market requires.
a. If the coupon rate is greater than the market (or effective) rate, the bonds will sell at a premium (i.e., at an amount greater than the face amount of the bonds).
b. If the coupon rate is less than the market rate, the bonds will sell at a discount. The issue price is determined by discounting the payments (principal and interest) to the present using the effective or market rate of interest.
2282.03
Debt issuance costs related to a debt liability are presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts.
2282.04
Example: To illustrate, assume the issuance of three-year bonds with a face amount of $100,000, which pay interest semi-annually at a contract rate of 8% per year. The issue price of the bonds is computed as follows under three different assumptions as to the market or effective interest rate.
