honeycfa

At the date of issuance the market interest rate was above the coupon rate. Bonds of this nature would sell for:

A) discount.

B) par.

C) premium.

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When the contract rate on a bond is lower than the market rate, a bond will sell for a discount.

honeycfa

Interest expense is reported on the income statement as a function of:

A) the market rate.

B) the coupon payment.

C) the unamortized bond discount.

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Interest expense is always equal to the book value of the bond at the beginning of the period multiplied by the market rate at issuance.

honeycfa

On December 31, 20X3 Okay Company issued 10,000 $1000 face value 10-year, 9% bonds to yield 7%. The bonds pay interest semi-annually. On its financial statements (prepared under U.S. GAAP) for the year ended December 31, 20X4, the effect of this bond on Okay's cash flow from operations is:

A) -$700,000.

B) -$755,735.

C) -$900,000.

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The coupon payment is a cash outflow from operations. ($10,000,000 × 0.09) = $900,000.

honeycfa

On December 31, 2004, Newberg, Inc. issued 5,000 $1,000 face value seven percent bonds to yield six percent. The bonds pay interest semi-annually and are due December 31, 2011. On its December 31, 2005, income statement, Newburg should report interest expense of:

A) $300,000.

B) $350,000.

C) $316,448.

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Newberg, upon issuance of the bonds, recorded bonds payable of (N = (2 × 7) = 14, PMT = $175,000, I/Y = (6/2) = 3, FV = $5,000,000) $5,282,402. Interest paid June 30, 2005, was ($5,282,402 × (0.06 / 2) =) $158,472. The coupon payment was $175,000, reducing bonds payable to ($5,282,402 – ($175,000 - $158,472) =) $5,265,874. Interest paid December 31, 2005, was ($5,265,874 × (0.06 / 2) =) $157,976. Total interest paid in 2005 was ($158,472 + $157,976 =) $316,448.

honeycfa

Assume a city issues a $5 million bond to build a new arena. The bond pays 8 percent semiannual interest and will mature in 10 years. Current interest rates are 9%. Interest expense in the second semiannual period is closest to:

A) $106,550.

B) $210,830.

C) $80,000.

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Step 1: Compute the present value of the bond: Since the current interest rate is above the coupon rate the bond will be issued at a discount.

FV = $5,000,000; N = 20; PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT → PV = -$4,674,802

Step 2: Compute the interest expense at the end of the first period.

= (0.045)(4,674,802) = $210,366

Step 3: Compute the interest expense at the end of the second period.

= (new balance sheet liability)(current interest rate)

= $4,674,802 + $10,366 = $4,685,168 new balance sheet liability

(0.045)(4,685,168) = $210,833

honeycfa

A bond is issued with the following data:

• $10 million face value.
• 9% coupon rate.
• 8% market rate.
• 3-year bond with semiannual payments.

Assuming market rates do not change, what will the bond's market value be one year from now and what is the total interest expense over the life of the bond?

Value in 1-Year

Total Interest Expense

A) 10,181,495  2,962,107

B) 11,099,495  2,437,893

C) 10,181,495   2,437,893

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To determine the bond's market value one year from now: FV = 10,000,000; N = 4; I = 4; PMT = 450,000; CPT → PV = $10,181,495.

To determine the total interest expense:

1. FV = 10,000,000; N = 6; I = 4; PMT = 450,000; CPT → PV = $10,262,107. This is the price the purchaser of the bond will pay to the issuer of the bond. From the issuer's point of view this is the amount the issuer will receive from the bondholder.
2. Total interest expense over the life of the bond is equal to the difference between the amount paid by the issuer and the amount received from the bondholder.

[(6)(450,000) + 10,000,000] – 10,262,107 = 2,437,893

honeycfa

A bond is issued with an 8 percent semiannual coupon rate, 5 years to maturity, and a par value of $1000. What is the liability at the beginning of the third period if market interest rates are 10%?

A) 929.

B) 923.

C) 935.

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Beginning liability of the third period = liability of the second period + difference in the cash payment and the interest expense for the third period.

Liability for the first period = present value of the bond present value of the bond is computed as follows: FV = 1000 PMT = [(1000)(0.08)]/2 = 40 I/Y = 5 N = 10 Compute PV = -923

Liability for the second period = 923 + [(0.05)(923) – 40] = 923 + 6 = 929

Liability for the third period = 929 + [(0.05)(929) – 40] = 929 + 6 = 935

honeycfa

When the market rate is greater than the coupon rate, the bond is called a:

A) par bond.

B) premium bond.

C) discount bond.

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When the market rate is greater than the coupon rate, the bond will sell at a discount as investors will only buy the bond at a price which is less than fair value due to the coupon being lower than the market rate.

honeycfa

The real estate group of a manufacturing company needs to finance a large construction project. The CEO wants to use zero coupon bonds, because “they are easy to understand.” The Executive Vice President (EVP) recommends a bond issued with a coupon rate greater than the current market rate of interest. A consultant recommends a bond issued at par. Regarding the financial and cash flow impact, which of the following statements is least accurate? All else equal, if the company follows the:

A) CEO's recommendation, there will be no impact on cash flow from operations.

B) EVP's suggestion, both the cash flow from financing and cash flow from operations will be understated compared to that of the par value bond recommended by the consultant.

C) EVP's suggestion, interest expense will decrease over time.

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If the company issues a premium bond (defined as coupon rate greater than the current market rate), the cash flow from financing will be overstated and cash flow from operations will be understated compared to the par value bond recommended by the consultant.

The other statements are true. With the premium bond, interest expense decreases over time because the carrying value of the bond decreases as the unamortized premium decreases by the difference between the coupon payment and the interest expense (market rate times carrying value.) All cash flows for a zero-coupon bond are financing cash flows, but the bond still has interest expense (used to amortize the unamortized discount account).

honeycfa

An analyst is considering a bond with the following characteristics:

• Face value = $10.0 million
• Annual coupon = 5.6%
• Market yield at issuance = 6.5%
• 5 year maturity

At issuance the bond will:

A) provide cash flow from investing of approximately $9.626 million.

B) increase total assets by $9.626 million.

C) increase total liabilities by $10.0 million.

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First we must determine the present value of the bond. FV = 10,000,000; PMT = 560,000; I/Y = 6.5; N = 5; CPT → PV = 9,625,989, or approximately $9.626 million. At issuance, the university will receive cash flow from financing of $9.626 million.

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Using the effective interest method, the interest expense in year 3 and the total interest paid over the bond life are approximately:

Year 3 Interest Expense

Total Interest

A) $560,000 $2.80 million

B) $634,506 $3.17 million

C) $560,000 $3.17 million

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• Interest expense in any given year is calculated by multiplying the market interest rate (at time of issuance) by the bond carrying value. For example, in year 1, interest expense = 9,625,989 × 0.065 = 625,689. Since the coupon payment = 10,000,000 × 0.056 = 560,000, the interest expense is “too high” by 65,689, and the carrying value of the bond is increased (through a decrease in the unamortized bond discount account) to $9,691,678. In year 2, using a similar calculation, the carrying value of the bond increases to $9,761,637. Thus, the interest expense in year 3 = 9,761,637 × 0.065 = 634,506, or approximately $0.635 million.

   

• Total interest expense is equal to the amount paid by the issuer less the amount received from the bondholder.

Amount paid by issuer = face value + total coupon payments
= 10,000,000 + (0.056 × 10,000,000 × 5) = 12,800,000
Total interest paid over the life = 12,800,000 – 9,625, 989 = 3,174,011, or approximately $3.2 million.