Chapter 12: 5RQ (page 654)
What is the difference betwee the stated interest rate and the market interest rate?
The stated and market interest rates are different in many ways. Both play a vitol role in the bond market.
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Bill and Edna had been married two years and had just reached the point where they
had enough savings to start investing. Bill’s uncle Dave told them that he had recently
inherited some very rare railroad bonds from his grandmother’s estate. He wanted
to help Bill and Edna get a start in the world and would sell them 50 of the bonds at
\(100 each. The bonds were dated 1873, beautifully engraved, showing a face value of
\)1,000 each. Uncle Dave pointed out that “United States of America” was printed
prominently at the top and that the U.S. government had established a sinking fund to
retire the old railroad bonds. A sinking fund is a fund established for the purpose of
repaying the debt. It allows the organization (the U.S. government, in this example)
to set aside money over time to retire the bonds. All Bill and Edna needed to do was
hold on to them until the government contacted them, and they would eventually get
the full \(1,000 for each bond. Bill and Edna were overjoyed—until a year later when
they saw the exact same bonds for sale at a coin and stamp shop priced as “collectors’
items” for \)9.95 each!
Requirements
1. If a company goes bankrupt, what happens to the bonds it issued and the investorswho bought the bonds?
2. When investing in bonds, how can you tell whether the bond issue is a legitimatetransaction?
3. Is there a way to determine the relative risk of corporate bonds?
Journalizing liability transactions and reporting them on the balance
sheet
The following transactions of Johnson Pharmacies occurred during 2018 and 2019:
2018
Mar. 1 Borrowed \(450,000 from Coconut Creek Bank. The 15-year, 5% note requires
payments due annually, on March 1. Each payment consists of \)30,000 principal
plus one year’s interest.
Dec. 1 Mortgaged the warehouse for \(250,000 cash with Saputo Bank. The mortgage
requires monthly payments of \)8,000. The interest rate on the note is 12% and
accrues monthly. The first payment is due on January 1, 2019.
31 Recorded interest accrued on the Saputo Bank note.
31 Recorded interest accrued on the Coconut Creek Bank note.
2019
Jan. 1 Paid Saputo Bank monthly mortgage payment.
Feb. 1 Paid Saputo Bank monthly mortgage payment.
Mar. 1 Paid Saputo Bank monthly mortgage payment.
1 Paid first installment on note due to Coconut Creek Bank.
Requirements
1. Journalize the transactions in the Johnson Pharmacies general journal. Round to
the nearest dollar. Explanations are not required.
2. Prepare the liabilities section of the balance sheet for Johnson Pharmacies on
March 1, 2019 after all the journal entries are recorded.
Determining bond amounts
Savvy Drive-Ins borrowed money by issuing $3,500,000 of 9% bonds payable
at 99.5. Interest is paid semiannually.
Requirements
1. How much cash did Savvy receive when it issued the bonds payable?
2. How much must Savvy pay back at maturity?
3. How much cash interest will Savvy pay each six months?
Analyzing alternative plans to raise money
SB Electronics is considering two plans for raising \(4,000,000 to expand operations.
Plan A is to issue 9% bonds payable, and plan B is to issue 500,000 shares of common
stock. Before any new financing, SB Electronics has net income of \)350,000 and
300,000 shares of common stock outstanding. Management believes the company can
use the new funds to earn additional income of $700,000 before interest and taxes.
The income tax rate is 30%. Analyze the SB Electronics situation to determine which
plan will result in higher earnings per share. Use Exhibit 12-6 as a guide.
Journalizing bond issuance and interest payments
On June 30, Parker Company issued 11%, five-year bonds payable with a face value
of $120,000. The bonds are issued at face value and pay interest on June 30 and
December 31.
Requirements
1. Journalize the issuance of the bonds on June 30.
2. Journalize the semiannual interest payment on December 31
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