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. | |
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.
Using the effective interest method, the interest expense in year 3 and the total interest paid over the bond life are approximately:
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Year 3 Interest Expense |
Total Interest |
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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.
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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.
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