Long Term Debt Flashcards
A company issued a short-term note payable to a bank with a stated 12 percent rate of interest . The bank charged a .5% loan origination fee and remitted the balance to the company.
The effective interest rate paid by the company in this transaction would be:
The .5% loan origination fee reduces the proceeds to the borrower AND increases the total interest to be paid by the same amount. The effect is to raise the interest rate above 12.5%.
Assume the loan amount is $1,000 before the loan origination fee. Therefore, the net amount loaned is $995 [1 - .005($1,000)]. However, the full $1,000 must be paid at maturity. The total interest to be paid is thus increased by the $5 origination fee ($1,000 - $995).
For simplicity, assume the loan is for a full year. Then total interest paid is: .12($1,000) + $5 = $125.
The effective rate of interest for the year then is: $125/$995 = .1256. This exceeds 12.5%.
Which of the following is reported as interest expense?
A. Pension cost interest.
B. Postretirement healthcare benefits interest
C. Imputed interest on noninterest-bearing note
D. Interest incurred to finance construction of machinery for own use
C. A noninterest-bearing note actually causes interest to be paid by the maker. The term noninterest-bearing means that the note carries no stated rate of interest. The face value of the note includes interest however, and exceeds the principal amount of the note (the amount borrowed).
For example, a firm might borrow $4,000 and sign a $5,000 noninterest-bearing note. When the firm pays the $5,000 at maturity, it will be paying $1,000 in interest. The term “imputed” interest means that in computing interest expense, the amount of interest implied in the note (difference between face value and principal) is used to compute the interest rate for recognizing interest expense over the term of the note.
