Question

BE17-1 Garfield Company purchased, as a held-to-maturity investment, $80,000 of the 9%, 5-year bonds of

Chester Corporation for $74,086, which provides an 11% return. Prepare Garfield's journal entries for (a)the purchase of the investment, and
(b) the receipt of annual interest and discount amortization. Assume
effective-interest amortization is used.
BE17-2 Use the information from BE17-1, but assume the bonds are purchased as an available-for-sale security.
Prepare Garfield's journal entries for
(a) the purchase of the investment,
(b) the receipt of annual
interest and discount amortization, and
(c) the year-end fair value adjustment. The bonds have a year-end
fair value of $75,500.

Answer 1

If interest rates rise to 9%, you would pay less than the $10,000 face value for a bond with a 6% coupon rate. Calculating the present value of the bond's future cash flows at the new interest rate results in a price of $9724.77. Thus, you would be willing to purchase the bond at this price, reflecting the adjusted market yield.

Step-by-step explanation:

When considering the purchase of a bond such as the one issued by the local water company with a face value of $10,000 and a coupon rate of 6%, if interest rates have increased to 9%, you would expect to pay less than the face value for the bond. The increase in the market interest rate makes the bond's fixed interest payments less attractive, hence the bond's price will decrease to yield a return in line with the current interest rate of 9%.

To calculate the bond's price, we simply discount the bond's future cash flows (interest payments and principal repayment) at the new market interest rate of 9%. In this case, because it is one year before maturity, the bond's future cash flows consist of a single interest payment of $600 (6% of $10,000) and the repayment of the principal of $10,000 at the end of the year. Using the present value formula Present Value = Future Value / (1 + Rate)^n, where n is the number of periods:

• Present Value of Interest Payment = $600 / (1 + 0.09)^1 = $550.46
• Present Value of Principal Repayment = $10,000 / (1 + 0.09)^1 = $9174.31

Summing these up gives us the bond's price of $550.46 + $9174.31 = $9724.77.

Therefore, you would be willing to pay $9724.77 for the $10,000 bond one year before maturity when the market interest rate is at 9%.