andytrader

Larry Purcell, an entry-level fixed income analyst at Knowlton & Smeades LLC, was discussing debt covenants with his supervisor, Andy Holzman. During the meeting Purcell made the following statements regarding bond covenants:
Statement 1: If a firm violates any of its debt covenants, the company will immediately go into bankruptcy and the creditors of the firm will take over the liquidation of its assets.
Statement 2: Debt covenants are important in evaluating a firm’s credit risk and to better understand how the restrictions of the covenants can affect the firm’s growth prospects and choice of accounting policies.
With respect to these statements:

A) only one is correct.

B) both are incorrect.

C) both are correct.

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Lenders and other creditors use debt covenants in their lending agreements to restrict the activities of the debtor that could adversely impact the creditors’ position. If any bond covenant is violated, the firm is in technical default on its debt. The creditors can demand payment of the debt, however, the terms are generally renegotiated. As such, the company does not automatically enter into bankruptcy and have its assets liquidated by the creditors.

andytrader

A company redeems $10,000,000 of bonds that it issued at par value for 101% of par or $10,100,000. In its statement of cash flows, the company will report this transaction as a:

A) 10,100,000 CFF outflow.

B) $10,000,000 CFF outflow and $100,000 CFO outflow.

C) $10,100,000 CFO outflow.

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Cash paid to redeem a bond is classified as a cash flow from financing activities.

andytrader

A firm can recognize a gain or loss on derecognition of a bond the firm has issued:

A) either before maturity or at maturity.

B) before maturity, but not at maturity.

C) at maturity, but not before maturity.

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If a firm redeems a bond before maturity for a price that is different from the carrying value of the bond liability, the firm will recognize the difference as a gain or a loss. At maturity, the carrying value of the bond liability is equal to the face value of the bond, therefore the firm does not experience a gain or loss by repaying the face value.

andytrader

At the beginning of 20X3, Creston Company issues $10 million face amount of 6% coupon bonds when the market rate of interest is 7%. The bonds mature in four years and pay interest annually. Assuming the effective interest rate method, what is the bond liability Creston will report at the end of 20X3?

A) $9,661,279

B) $9,737,568

C) $10,346,511

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Under the effective interest rate method, the bond liability is equal to the present value of the remaining cash flows discounted at the market rate of interest at the issue date. At the end of this year, there are 3 annual payments of $600,000 and one payment of $10,000,000 remaining. Using your financial calculator, the present value is $9,737,568 (N = 3, I = 7, PMT = 600,000, FV = 10,000,000, Solve for PV).

andytrader

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) -$900,000.

C) -$755,735.

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

andytrader

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) increase total assets by $9.626 million.

B) provide cash flow from investing of approximately $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.

andytrader

For a firm financed with common stock and long-term fixed-rate debt, an analyst should most appropriately adjust which of the following items for a change in market interest rates?

A) Interest expense.

B) Cash flow from financing.

C) Debt-to-equity ratio.

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For the purpose of analysis, the value of debt should be adjusted for a change in interest rates. This will change the debt-to-equity ratio. Because changes in interest rates will change the market value of the debt, but not the coupon, interest expense will be unchanged. (However, if a firm has variable-rate debt, interest expense will change when interest rates change, but the market value of the variable-rate debt will not change significantly.)

andytrader

Which of the following statements for a bond issued with a coupon rate above the market rate of interest is least accurate?

A) The bond will be shown on the balance sheet at the premium value.

B) The value of the bond will be amortized toward zero over the life of the bond.

C) The associated interest expense will be lower than that implied by the coupon rate.

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The value of the bond’s premium will be amortized toward zero over the life of the bond, not the value of the bond.

andytrader

When bonds are issued at a premium:

A) coupon interest paid decreases each period as bond premium is amortized.

B) earnings of the firm decrease over the life of the bond as the bond premium is amortized.

C) earnings of the firm increase over the life of the bond as the bond premium is amortized.

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As bond premium is amortized, interest expense will be successively lower each period, thus increasing earnings over the life of the bond.

andytrader

A firm issues a $5 million zero coupon bond with a maturity of four years when market rates are 8%. Assuming semiannual compounding periods, the total interest on this bond is:

A) $1,346,549.

B) $1,200,000.

C) $1,600,000.

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The interest paid on the bond will be the difference between the future value of the bond of $5,000,000 and the proceeds of the bond when it was originally issued.
First find the present value of the bond found by N = 8; FV = 5,000,000; I = 4; PMT = 0; CPT → PV = −3,653,451.  This is the amount of money the bond generated when it was originally issued.
Then take the difference between the $5,000,000 future price and the $3,653,451 from the proceeds  = $1,346,549 which is the interest paid on the bond.