1215

When bonds are issued at a premium:

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

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

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

---

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

1215

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.

---

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

1215

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) Debt-to-equity ratio.

C) Cash flow from financing.

---

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.)

1215

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.

---

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

1215

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

---

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

1215

Nomad Company issued $1,000,000 face value 2-year zero coupon bonds on December 31, 20X2 to yield 8% interest. Bond proceeds were $857,339. In 20X3 Nomad recorded interest expense of $68,587. In 20X4 Nomad recorded interest expense of $74,074 and paid out $1,000,000 to redeem the bonds. Based on these transactions only, Nomad’s Statement of Cash Flows would show cash flow from operations (CFO) of:

A) zero in all years.

B) -$68,587 in 20X3 and -$74,074 in 20X4.

C) -$142,661 in 20X4.

---

All of the cash flows for zero coupon bonds are included in cash flow from financing activities and none in cash flow from operations.