Question

On the first day of its fiscal year, ebert company issued $11,000,000 of 10-year, 7% bonds to finance its operations. Interest is payable semiannually. The bonds were issued at a market (effective) interest rate of 9%, resulting in ebert receiving cash of $9,569,097. The company uses the interest method. Required ________.

a. Journalize the entries to record the following transactions. Refer to the chart of accounts for exact wording of account titles 1. Sale of the bonds on January 1 2. First semiannual interest payment on June 30, including amortization of discount. Round to the nearest dollar. 3. Second semiannual interest payment on December 31, including amortization of discount. Round to the nearest dollar.
b. Compute the amount of the bond interest expense for the first year
c. Explain why the company was able to issue the bonds for only $9,569,097 rather than for the face amount of $11,000,000.

Answer 1

You would expect to pay less than the face value of a bond if market interest rates rise above the bond's coupon rate. For a $10,000 bond with a 6% coupon rate and market rates at 9%, the price calculated using the present value formula would be $9,724.31, reflecting the bond's discounted value a year before maturity.

Step-by-step explanation:

When considering the purchase of a bond one year before its maturity, with interest rates higher than the bond's coupon rate, you would generally expect to pay less than the face value of the bond. In the scenario described, the local water company issued a $10,000 bond with a 6% coupon rate. A few years later, with market interest rates at 9%, the market price of the bond will decrease so that the new buyer's yield matches the current market rate.

To calculate the price you would be willing to pay for the bond, you would discount the bond's future cash flows (one more interest payment and the principal repayment) using the current market interest rate of 9%. For a simple bond with a single payment left, you'd use the formula PV = CF / (1 + r), where PV = present value, CF = cash flow in one year, and r = discount rate.

Using this formula, if you're buying the bond one year before maturity, you would expect the cash flow to be the final interest payment plus the face value of the bond. Assuming a $600 interest payment ($10,000 * 6%), plus the $10,000 principal repayment, the cash flow would be $10,600. Thus, the price you'd be willing to pay is $10,600 / (1 + 0.09) = $9,724.31.