Revsine FRA 8e Chap012 SM
Revsine FRA 8e Chap012 SM
)
Chapter 12 Solutions
Financial Instruments and Liabilities
Exercises
Exercises
We know that the bonds were priced to yield 8% when the contract interest
rate was only 6%. Since the yield is higher than the contract interest rate, we
know the bonds were sold at a discount, and we must use the yield to
maturity to find interest expense and the price of the bond.
12-1
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-2. Determining market price following a change in interest rate (LO 12-2)
Now we’ve moved one year closer to the maturity date. So, two aspects of
the calculation in E12-1 will have changed: The yield to maturity is now 10%
(or 5% per period), and there are 18 periods to maturity.
12-2
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-3. Finding the discount at Issuance (LO 12-2)
To find the amount of amortization on July 1, 20X1 we first need to know the
book value of the bond on that date. Since this is the first interest payment
date, the beginning-of-period book value is the same as the original issue
(selling) price, which is the face value less any discount (or plus any
premium). With this knowledge, we can find the interest payable and the
interest expense using the effective and stated interest rates respectively, as
is done below.
Discount ($52,970)
Semiannual:
7/1/X1 Interest expense (7% of $447,030) 31,292
12-3
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-4. Determining a bond’s balance sheet value (LO 12-2)
(AICPA adapted)
Even though the bonds pay interest only annually on December 31, the
June 30 balance sheet would still need to reflect interest accrued since the
issue date:
The June 30 book value of the bond is $470,475 or the original issue price of
$469,500 plus the $975 discount amortization.
12-4
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-5. Calculating gain or loss at early retirement (LO 12-3)
(AICPA adapted)
The reacquisition price is the cash paid out by Davis to reacquire its bonds.
Since it is less than the book value of the bonds, the company realizes a gain
on the retirement of its debt.
12-5
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-6. Amortizing a premium (LO 12-2)
(AICPA adapted)
To find the amount of unamortized premium on June 30, 20X2, we first need
to find the interest expense for 20X2 (6% of the June 30, 20X1, book value,
6% of $105,000).
The carrying (or book) value of the bond on June 30, 20X2, is $104,300. We
know that the face value of the bond is $100,000 and the book value is
$104,300; the difference between the face value and book value of the bond
must be the unamortized premium. So Webb should report $4,300 of
unamortized premium in its June 30, 20X2, balance sheet.
12-6
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-7. Zero coupon bond (LO 12-2)
Requirement 1:
These bonds have a face value of $250 million, a zero coupon rate, a
market yield rate of 12%, and mature in 20 years. The issue price is:
If the market interest rate is instead 12% semi-annually (6% each period for
40 periods), then the bond issue price would be $24,305,547.
Alternatively, using PV tables: $250 million x .09722 = $24,305,000
Requirement 2:
How much interest expense would the company record on the bonds in
20X1? Although the bonds don’t pay interest, an expense would still be
recorded:
Requirement 3:
Interest expense in 20X2 would be:
12-7
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-8. Floating-rate debt (LO 12-5)
Requirement 1:
The floating interest rate for 20X1, set on January 1 of that year, was 12%
or the LIBOR rate of 6% plus 6% additional interest. The 20X1 interest
payment was $24 million ($12 million every 6 months), or the $200 million
borrowed multiplied by the 12% floating rate for the year.
For 20X2, the floating rate will be 14%, or a LIBOR rate of 8% plus 6%
additional interest. So the company will pay out $28 million ($14 million
every 6 months) in interest that year, or $200 million borrowed multiplied by
the 14% floating rate for the year.
Requirement 2:
The debentures were issued at par for $200 million, so there is no discount
or premium to amortize. Interest expense just equals the required cash
interest payment: $24 million in 20X1 and $28 million in 20X2.
12-8
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-9. Identifying incentives for early debt retirement (LO 12-3)
Requirement 1:
We must first determine the book value of the bonds on December 31, 20X1
—almost two years after issuance. That would seem easy because the
bonds were issued at par, but there is a catch: The interest payment due
that day has not yet been paid, so we must bring the books up to date by
first recording accrued interest from July 1 through December 31:
The total book value (including Interest) of the debt on December 31, 20X1,
is $130 million, the $125 million borrowed plus the $5 million of interest
owed for July 1 through December 31.
The market value of the bonds on December 31, 20X1, is: $125 million face
value, 8% coupon rate paid semi-annually, 13 years to maturity, and yield of
12%:
12-9
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 2:
There are several reasons a company might want to retire debt early: take
advantage of lower interest rates; postpone scheduled principal
repayments; eliminate a conversion feature attached to the debt; improve
the company’s mix of debt and equity capital; or earnings management
using the “paper” gains from debt retirement. However, unless the company
is awash in cash, voluntary retirement is unlikely since the debt would have
to be replaced at a higher (12%) interest cost.
12-10
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-10. Early extinguishment of debt (LO 12-2, LO 12-3)
Because the coupon and market rates are equal, the bonds will sell for par value, or
$250,000,000. We can check this result by using present value tables as follows.
Payment $ 10,000,000* X pvoa 20,4% 13.59033 $135,903,300
Principal 250,000,000 X pv 20,4% 0.45639 114,097,500
$250,000,800
The computed amount does not equal $250,000,000 because the present value
factors are rounded to only five digits. When we use the Excel pv function (or a
financial calculator) with the assumptions of rate=4%, nper=20, pmt=10,000,000,
and fv=250,000,000 without rounding, we obtain the $250,000,000.
Remaining periods 16
Market rate 6%
Payments per year 2
Payment 10,000,000 X pvoa 16,3.0% 12.56110 125,611,000
Principal 250,000,000 X pv 16,3.0% 0.62317 155,792,500
281,403,500
Requirement 3 – Journal entry if 50% of the bonds are retired on July 1, 20X3
12-11
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-11. Fair value option (LO 12-4)
The bonds will be shown at the par of $300 million because the coupon rates and
the market rates are the same.
January 1, 20X1
DR Cash 300,000,000
CR Bonds payable 300,000,000
To record bond issuance
After the second journal entry, the bonds payable net of the adjustment will reflect
fair value. The interest expense and unrealized gain would probably netted in one
financing expense line item on the income statement.
12-12
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 3 - Increase in interest rate and deteriorating financial condition
If the increase in interest rate were due to worsening financial health, the credit
would go to Other comprehensive income - Bonds payable unrealized gain.
Consequently, the gain would be part of Other comprehensive income (OCI)
instead of net income
12-13
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
E12-12. Noninterest-bearing loan (LO 12-6)
Requirement 1:
The present value of this payment stream, discounted at 9%, is:
Requirement 2:
The purchase would be recorded at its implied cash price of $451,822 as:
DR Equipment $451,822
CR Cash $100,000
CR Note payable 351,822
Interest expense at 9% per year on the unpaid balance would also be recorded over time.
Requirement 3:
McClelland should purchase from Agri-Products because it has offered the
best price.
12-14
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Financial Reporting and Analysis (8th Ed.)
Chapter 12 Solutions
Financial Instruments and Liabilities
Problems/Discussion Questions
Problems
P12-1. Imputing interest (LO 12-6)
Requirement 1:
To verify that the imputed interest rate on the dealer’s loan is 6%, compute
the present value of the payment stream using a 6% discount rate and
confirm that that present value is $19,326. Here is a schedule that shows
the present value of the payment stream at 6%:
Present
value
Down payment Payment factor
$2,000 1.00000 $2,000
Year 1 5,000 0.94340 4,717
Year 2 5,000 0.89000 4,450
Year 3 5,000 0.83962 4,198
Year 4 5,000 0.79209 3,960
Present value of payments $19,325
Requirement 2:
Greg has the funds needed to make the down payment, but must borrow
the remaining amount of purchase price. The dealer has offered Greg a 6%
loan, but the bank is only charging 5%. Greg should borrow from the bank
because it is the least expensive source of funds.
12-15
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-2. Reporting bonds issued at a discount (LO 12-2)
Requirement 1:
The issuance price of the bonds on July 1, 20X1 is equal to the present value
of the principal repayment plus the present value of the semi-annual interest
payments. Since the bonds pay interest semi-annually, the present value
calculations are based on a twenty-period horizon using a market interest rate
of 5% (i.e., 10%/2).
Requirement 2:
The amortization schedule appears below:
12-16
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 3:
The journal entries for the first four interest payments are:
12/31/20X1:
6/30/20X2:
12/31/20X2:
6/30/20X3:
Requirement 4:
The balance sheet presentation at 12/31/20X1 would be:
12-17
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-3. Reporting bonds issued at a premium (LO 12-2)
Requirement 1:
The issuance price of the bonds on January 1, 20X1, is equal to the present
value of the principal repayment plus the present value of the semi-annual
interest payments. Since the bonds pay interest semi-annually, the present
value calculations are based on a twenty-period horizon using a market
interest rate of 3% (i.e., 6%/2).
Requirement 2:
The amortization schedule appears below:
12-18
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 3:
The journal entries for the first four interest payments are:
6/30/20X1:
12/31/20X1:
6/30/20X2:
12/31/20X2:
Requirement 4:
The balance sheet presentation at 12/31/20X1 would be:
12-19
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-4. Analyzing installment note and imputed interest (LO 12-3)
Requirement 1:
To verify that the imputed interest rate on the installment note is 10%, we
compute the present value of the payment stream using a 10% discount rate
and confirm that that present value is $6,340. Here is a schedule that shows
the present value of the payment stream at 10%:
Present value
Down payment Payment factor
$0 1,00000 $0
December 31, 20X1 2,000 0.90909 1,818
December 31, 20X2 2,000 0.82645 1,653
December 31, 20X3 2,000 0.75132 1,503
December 31, 20X4 2,000 0.68301 1366
Present value of payments $6,340
Requirement 2:
The following journal entry would be made on January 1, 20X1 to record the
purchase:
DR Equipment $6,340
CR Installment note payable $6,340
Requirements 3 and 4:
The following schedule shows interest expense and the loan balance for each
year:
Interest expense for 20X1 would be $634 and the loan balance at year-end
would be $4,974. Interest expense for 20X2 would be $497 and the loan
balance at year-end would be $3,471. All amounts are rounded to the nearest
dollar.
12-20
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-5. Understanding the Fair Value Option (LO 12-4)
Requirement 1:
Mason would make the following entry to record the borrowing and initial
purchase of its corporate bond investment:
January 1, 20X1:
DR Cash $500,000
CR Loan payable $500,000
12-21
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 2:
Ignoring interest, the carrying value of the loan under conventional historical
cost accounting would be $500,000 at the end of each quarter. The reason is
that changes in loan (i. e., debt) fair value are ignored under conventional
historical cost accounting for debt.
Requirement 3:
If Mason elects to use the fair value option for debt permitted by ASC Topic
825, the loan’s carrying value would be reset to its fair value each quarter.
The entries to do so are:
As before, unrealized holding gains and losses flow to the income statement.
The Market adjustment account flows to the balance sheet as a contra-liability
so that the loan is carried at fair value each quarter. Notice that unrealized
gains on Mason Manufacturing’s loan payable partially offset unrealized
losses on its corporate bond investments.
Requirement 4:
Proponents of the fair value option for debt argue that this offset feature
(described in Requirement 3) helps to insulate the income statement from
artificial volatility when inter-corporate investments are financed with loans.
Critics of the fair value option claim that the entries in Requirement 3 mask
the fact that Mason continues to owe the full amount borrowed ($500,000)
despite temporary fluctuations in debt fair value.
P12-6. Fair value option and retiring debt early (LO 12-2, LO 12-3, LO 12-4)
$3,000,000 = $75,000,000 x 8% ÷ 2.
January 1, 20X1
DR Cash 75,000,000
CR Bonds payable 75,000,000
To record bond issuance
After the second journal entry, the bonds payable net of the adjustment
will reflect fair value. The interest expense and unrealized gain would
probably be netted in one financing expense line item on the income
statement.
12-23
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
*Price adjustment calculation
Remaining periods 18
Market rate 6%
Payments per year 2
12-24
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
a
Price adjustment that effects net income
The fair value changes because there are fewer payments remaining.
Remaining periods 1
6
Market rate 6%
Payments per year 2
b
Price adjustment that affects OCI
Remaining periods 16
Market rate 10%
Payments per year 2
12-25
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 4 - Bond retirement on 1/1/20X3
The gain is lower because the debt had not been increased to fair value in prior years.
12-26
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-7. Fair value option (LO 12-4)
Requirement 1:
The bonds were issued on January 1, 20X1 at par, so the proceeds received
by Kahn were equal to the face value ($500 million) of the bonds. There was
no discount or premium to amortize. Interest expense for 20X1 and each
year thereafter is $30 million ($500 million x 6% annual interest). Because
the bonds were issued at par and there was no discount or premium to
amortize, the carrying value on January 1, 20X5 is $500 million.
Requirement 2:
Using a market interest rate of 12%, the market value of the bonds on
January 1, 20X5 is $363,807,304.
Requirement 3:
Let’s illustrate the effect of escalating credit risk using the results in
Requirements 1 and 2. Investors who believe on January 1, 20X1 that
Kahn’s credit risk is accurately captured by the 6% stated interest rate will be
willing to pay par value ($500 million) for the bonds. As the chapter explains,
if investors believed that Kahn’s credit risk was higher than that implied by
6%, the bonds would be issued for an amount less than par value and the
effective (market) interest rate would be higher than 6%.
Now, let’s jump forward in time. If investors still believed on January 1, 20X5
that Kahn’s credit risk is accurately captured by the 6% stated interest rate,
they will continue to price the bonds at par value ($500 million). [You should
verify this fact.] On the other hand, if investors perceive that Kahn’s credit
risk has increased, the fair value of the bonds will decline to reflect the higher
likelihood of nonpayment. Investors who believe that Kahn’s credit risk is
accurately captured by a 12% interest rate will assign a value of only $363.8
million (rounded) to the bonds. Under this scenario, the value to investors of
Kahn’s has declined in the marketplace because the perceived risk of
nonpayment by Kahn has increased.
Requirement 4:
Kahn elected to use the fair value option in accounting for its debt, and thus
recorded the following journal entry:
The fair value adjustment reduces the balance sheet carrying value of the
bonds, and the unrealized holding gain flows to the income statement and
increases reported earnings for the period.
Requirement 5:
12-27
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Opponents of the fair value accounting option for debt point to the counter-
intuitive financial statement result: as a company’s credit risk increases and
the slow march toward bankruptcy ensues, it reports higher earnings because
of the fair value accounting option’s “unrealized holding gain.” This additional
earnings also increases reported stockholders’ equity, yet it is difficult to
believe that shareholders reap economic gains as the company heads to
bankruptcy. Moreover, opponents argue, the company remains legally
obligated to repay the entire amount borrowed (plus interest), not some
smaller amount represented by the debt’s fair value.
12-28
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-8. Discount and premium amortization (LO 12-2)
Requirement 1:
The carrying values of both bonds in each of the two years presented is
simply equal to the present value of the principal and interest payments
discounted over the remaining life of the bond. To illustrate, the December
31, 20X3, value of $9,653,550 for the 10% bonds due in 20X5 can be
derived as follows. Note that these bonds pay semi-annual interest of
$500,000 and have four periods until they mature. Present value of the
principal repayment:
4 periods at 6%
= $500,000 x 3.4651 = $1,732,550
In a similar fashion, the December 31, 20X4, value of $10,362,950 for the
10% bonds due in 20X6 can be derived as follows. Note that these bonds
pay semi-annual interest of $500,000 and have four periods until they
mature.
12-29
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
The December 31, 20X4 carrying value of the 10% bonds due in 20X5 is
equal to the present value of the principal repayment to be received in 2
periods plus the present value of the 2 remaining interest payments
discounted at the original market rate of 6% (i.e., 12%/2).
The December 31, 20X3, carrying value of the 10% bonds due in 20X6 is
equal to the present value of the principal repayment to be received in 6
periods plus the present value of the 6 remaining interest payments
discounted at the original market rate of 4% (i.e., 8%/2).
12-30
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 2:
The amount of interest expense recognized in 20X4 on the bonds due in
20X5 is equal to the cash interest payment of $1 million ($500,000 on both
June 30 and December 31) plus the amortization of the bond discount
during 20X4. This latter amount is the difference between the carrying value
of the bonds at December 31, 20X3, and December 31, 20X4. Based on the
calculations in part 1, this amount is:
Requirement 3:
The amount of interest expense recognized in 20X4 on the bonds due in
20X6 is equal to the cash interest payment of $1 million ($500,000 on both
June 30 and December 31) minus the amortization of the bond premium
during 20X4. This latter amount is the difference between the carrying value
of the bonds at December 31, 20X3, and December 31, 20X4. Based on the
calculations in part 1, this amount is:
12-31
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-9. Reading the Financials (LO 12-1, LO 12-2, LO 12-7)
Requirement 1:
There are two correct solutions to this requirement, depending upon how
you interpret the company’s “14.6% effective rate” disclosure. If this is the
annual effective interest rate then interest expense for the year is found by
multiplying the beginning book value of the debt by its effective interest rate:
Notice that interest expense is different from the cash interest payment,
which can be found by multiplying the debt face value by the stated interest
rate:
The discount amortization is the difference between the expense and cash
payment shown above, or $5,674,200 = $26,674,200 minus $21,000,000.
The book value change shown on the balance sheet is $5,900,000 (or
$188.6 million minus $182.7 million). The discount amortization should
equal the change in balance sheet book values, but the two numbers differ
here because of rounding in the reported interest rate or in the reported
book values.
Requirement 2:
12-32
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
There are two ways to compute interest expense on the zero coupon bonds:
Interest expense = $239,200,000 x 12.0% = $28,704,000
Or, since the entire expense is amortized (there’s no cash payment), it is all
added to the debt book value. Consequently, interest expense will equal the
increase in carrying value of the bonds, or:
Requirement 3:
The following entry would have been made on December 31, Year 2, for the
participating mortgages:
Requirement 4:
The zero coupon bonds do not pay cash interest. $21 million was paid out
on the 7% debentures, i.e., $300 million face value times 7%.
12-33
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-10. Working backward from an amortization table (LO 12-2)
Requirement 1:
Compute:
Requirement 2:
At the time of issuance, the bondholders exchanged today’s cash flow for
tomorrow’s, but with the same present value on a risk-adjusted basis.
Consequently, neither the borrower nor the lender made a profit (or loss) at
the time of the issuance of bonds. Consequently, no gain or loss should be
recorded at that time. The discount/premium merely reflects the difference
between the face value and the price of the bonds, a difference that arises
because the stated interest rate is not equal to the market yield (effective)
rate. Amortizing discounts and premiums over time allows interest expense
to be properly recorded at the true cost of borrowing.
Requirement 3:
It is the present value of an annuity of $25,000 for the next 5 periods plus
the present value of $500,000 to be received at the end of 5 periods, both
discounted at the original semi-annual effective rate of 4%.
Requirement 4:
New price of the bonds on January 1, 20X4, is:
The economic gain that results from the interest rate increase is:
Considering just the debt, the company and its shareholders are better off
because of the interest rate increase. The economic gain is the reduced
present value of debt payments (principal plus interest) at the new higher
interest rate. The cash outflow has a lower present value—indicating
bondholders will be receiving a less valuable payment stream.
12-34
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Of course, things get a bit more complicated when the interest rate increase
has a negative impact on the company’s other activities. For example, if the
company sells products to customers on an installment payment plan,
higher interest rates may lead to lower product sales. In addition, we have
presumed that interest rates have increased throughout the economy and
not just for this company.
12-35
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-11. Recording floating-rate debt (LO 12-5)
Requirement 1:
Journal entry to record the issuance on January 1, 20X1:
DR Cash $250,000,000
CR Bonds payable $250,000,000
If the bonds were issued at par, the effective (or market) interest rate must
have been equal to the stated rate of “LIBOR + 5.5%”, or 12%, since the
LIBOR was 6.5% at the issue date.
Requirement 2:
Interest expense for 20X1:
Requirement 3:
If the only factor influencing the market value of these bonds is the LIBOR,
the bonds will have a market value of $250 million on 12/31/20X3. This is
because the interest rate on the bonds is reset annually so that the present
value of the principal and remaining interest payments always equals $250
million at the new rate.
12-36
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-12. Debt-for-debt swaps (LO 12-4, LO 12-8)
Requirement 1:
Since the bonds were originally sold at par, the carrying amount on
December 31, 20X1 is equal to $5,000,000. If this bond issued were retired
in exchange for a bond issue valued at $3,200,000 there would be a pre-tax
gain of $1,800,000. The journal entry to record the exchange would be:
Requirement 2:
Long-term debt-to-equity ratio after the swap:
Requirement 3:
The transaction would increase net income by $1,422,000 (see above).
Requirement 4:
Other ways to avoid the covenant’s violation include: issue additional
common stock, reissue any treasury stock that is being held, make changes
to accounting methods (e.g., depreciation of assets, useful lives, salvage
values, etc.) that are income increasing, and/or exchange common stock for
some outstanding debt.
Requirement 5:
IFRS guidance stipulates that an exchange of financial instruments qualifies
as an extinguishment of debt only if the terms—stated interest rate,
duration, payment schedule, etc.—of the instruments are “substantially”
different. Absent substantial differences in terms, no extinguishment gain or
loss is recorded under IFRS. So, Chain Corporation would be required to
demonstrate that the terms associated with the old 7% coupon bonds and
the new 14% bonds are substantially different.
12-37
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-13. Zero coupon bonds (LO 12-2)
Requirement 1:
Korman issued $1.0 billion maturity value zero coupon debentures at a price
of $553.68 per $1,000 maturity value. The total cash proceeds to the
company (ignoring any investment banking fees associated with the
transaction) was:
Requirement 2:
The present value factor for a 3% yield to maturity over twenty years is
given by:
Requirement 3:
January 1, 20X0
12-38
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
December 31, 20X0
Requirement 4:
Interest rates throughout the economy have declined, making Korman’s 3%
zero coupon debentures even more attractive to investors who then bid up
the price of the company’s debt.
12-39
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
P12-14. Comprehensive problem on premium bond (LO 12-2)
The following schedule shows the details for most parts of this question.
Amortization Table
Bond
Bond Carrying (Premium) Premium Bond Carrying Cost
Payment Amount at Interest Discount (Discount) Amount at Interest Principal
Month/Year Period Start of Period Expense Amortization Balance End of Period Payment Payment
Requirement 1:
The July 1, 20X1 issue price is $27,917,110.
Requirement 2:
The partial amortization table is shown above.
Requirement 3:
Interest expense and cash interest payment information is given in the
amortization table. The entry for June 30, 20X2 is:
Requirement 4:
Points to be made include: the company received $27.9 million cash in
exchange for a promise to repay on $20 million in principal and $2.4 million
in interest each year; because more than $20 million was received, the true
interest rate is less than 6% each period; some of each year’s interest
payment is really a payment on the principal; to reflect these facts properly
on the books, interest expense is recorded at the true market rate (4% each
period) and using the true amount owed—book value of the debt including
unamortized premium.
Requirement 5:
From the amortization schedule in Requirement 1, we can see that the book
value of the entire debt issue is $26,665,225 on July 1, 20X7. So, the book
value of 40% of the debt would be $10,666,090 (rounded). If the company
exercised its call provision and retired 40% of the debt (or $8,000,000 face
value) at a price of 105, the following entry would be made:
Requirement 6:
If the market yield on the debt is 10%, its market price would be
$22,979,625 and 40% of the debt would have a market value of $9,191,850.
This means that the company paid $791,850 less by calling the debt than it
would have paid buying the debt on the open market.
12-41
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Financial Reporting and Analysis (8th Ed.)
Chapter 12 Solutions
Financial Instruments and Liabilities
Cases
Cases
C12-1. Century and beyond bonds (LO 12-1, LO 12-2)
Requirement 1: Present value of principal to price
The issue price of Draper’s $200 million century bonds is also $200 million.
The follows from the fact that the market yield (7.5%) exactly equals the
stated interest rate. A financial calculator on Excel spreadsheet is needed to
perform the detailed calculation of how much of the issue price comes from
the promised principal payment vs. interest payments. Here we sketch the
calculation.
What about the interest payment stream? Well, interest payments must
contribute the remaining amount of the issue price ($200,000,000 minus
$145,000) or $199.855 million. This represents 99.9275% of the issue price
To find the amount of tax savings lost if only the first 40 years of interest
payments are deductible, we first need to find the present value of the 40
year interest payment stream. Using a financial calculator or Excel
spreadsheet, you can determine that the present value of a 40 period annuity
of $15 million each year—the annual interest payment—at 7.5% is $188.916
million. The tax benefit of this 40-year deduction is $39.672 million ($188.916
million x 21%) in present value terms. This means that restricting the
deductibility of interest to the first 40 years will reduce the present value of the
12-42
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
tax savings by only $2.298 million ($41.970 million less $39.672 million), or
roughly 5.5%.
If the market yield is only 6.5%, the issue price becomes $230.713 million,
composed of an interest payment stream worth $230.344 million and a
principal payment worth $0.368 million.
Requirement 1:
$1,402 from the balance sheet
12-43
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 2:
$1,298 from the cash flow statement
Requirement 3:
The difference is $104. This appears to suggest that payment on the note
payable in Note 5 was not made during Year 2, but that it is included in the
current maturities amount of $2,747 as of the end of Year 2.From Note 5:
$2,747 - $1,794 - $416 - $432 = $105 $104 Rounded, where $416 is (4 x
$104) and $432 is (4 x$108).
Requirement 4:
Current portion is $2,747
$1,794
Remaining principal on note
432 4 quarterly installments on industrial development bond
416 4 quarterly installments on note payable
104 see Question #3
____1 Rounding
$2,747
Requirement 5:
Journal entry for March 31:
Requirement 6:
Journal entry for April 30:
12-44
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Requirement 7:
Journal entry for April 30, assuming full payment.
12-45
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
C12-3 Dentsply International: Analyzing long-term debt disclosures (LO 12-1,
LO 12-2, LO 12-7)
The debt composition changed little from 2011 to 2012. No new debt was
issued. “Other borrowings, various currencies and rates” declined slightly.
There are two features of this calculation to notice. First, the weighted-
average interest rate is not simply the average of the interest rates reported
in the financial statement note. Each reported interest rate is weighted by
the dollar amount of debt to which it is associated. Second, one category of
long-term debt (“Other borrowings..”) does not have an interest rate shown
in the table. This solutions assumes that Other borrowings have an interest
rate consistent with the weighted-average rate for Dentsply’s other loans
(3.01%).
12-46
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
expense arising from original issuance discounts and premia has been
ignored for purposes of this calculation since they are small in magnitude.
Compare this analysis to the one connected with the Chesapeake Energy
Corporation information in Exhibit 11.10. Chesapeake’s debt fair value was
less than the debt book value, and its cash from operations could not meet
its debt servicing. In addition, Chesapeake had to enter into a troubled debt
restructuring.
12-47
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
C12-4. Toys “R” Us: Identifying financial distress and potential bankruptcy (LO
12-2, LO 12-7)
This is a good case with which to get student participation. There are
numerous indicators of financial weakness. They are listed below.
12-48
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.