Question

Candlestick, Inc. issues $ 5,000,000 face value bonds, on January 1, 2020. The bonds are to mature exactly in 5 years' time. The stated interest rate on the bonds is 6%, and interest is paid annually on December 31 of every year. The market interest rate is 8%. Accordingly, the carrying value of the bonds payable on January 1\1\2020 is $4,600,810. The company uses the effective-interest method for amortization purposes.

On December 31112\2020, the journal entry includes:
a. None of the available choices
b. a credit to interest expense 368,065
c. a debit to cash 300,000 O c.
d. a debit to discount on bonds payable 68,065

Answer 1

Using the present value formula, the two-year bond with a face value of $3,000 and an interest rate of 8% is worth $3,000 when discounted at 8%. If the discount rate rises to 11%, the present value drops to $2,863.08, reflecting the decreased worth of the bond's future cash flows.

Step-by-step explanation:

To calculate the present value of a two-year bond with a face value of $3,000 and an annual interest rate of 8%, we use the present value formula to discount future cash flows back to their present value. For a discount rate of 8%, the present value of the bond would be the sum of the present values of the interest payments and the principal repayment. The present value of the first year's interest payment of $240 plus the second year's interest payment of $240 and the principal amount of $3,000 can be calculated using the formula for present value of an annuity and a single sum, respectively.

When the discount rate is 8%, the bond's present value is calculated as such:

1. First year interest payment: PV = $240 / (1 + 0.08) = $222.22
2. Second year interest and principal payment: PV = ($240 + $3,000) / (1 + 0.08)^2 = $2,777.78

The sum of these present values gives us the total present value of the bond, which is $222.22 + $2,777.78 = $3,000.

If interest rates rise and the discount rate becomes 11%, the present value calculation must be adjusted. Using the same process:

1. First year interest payment: PV = $240 / (1 + 0.11) = $216.22
2. Second year interest and principal payment: PV = ($240 + $3,000) / (1 + 0.11)^2 = $2,646.86

The sum of these present values is $216.22 + $2,646.86 = $2,863.08, the total present value of the bond at an 11% discount rate.