Final answer:
Allen Industries should use the incremental method to allocate proceeds from a bond sale with detachable warrants, assigning known market values to warrants first and the remaining amount to bonds. When market interest rates exceed the bond's rate, the bond's price drops to align its yield with current market rates.
Step-by-step explanation:
Allen Industries should allocate the proceeds of the bond sale with detachable warrants using the incremental method. In this scenario, since similar bonds without warrants sell for $99, and the market price of the warrants is $20, the allocation should be based on these market prices. Bonds with detachable warrants are essentially two securities: a bond and a warrant. The method dictates that proceeds should be first assigned to the securities with a known market value – which, in this case, are the warrants – and the residual amount to the bonds.
Considering the risk of the bond, if the bond carries no risk, it would sell at par value ($1,000) and pay $80 per year in interest. If market interest rates rise to 12%, the previously issued bond becomes less attractive because new bonds on the market may offer the higher current rate. Therefore, the price of the 8% bond would decrease below its face value of $1,000 to attract buyers. For example, the bond's price might be adjusted to $964, so that its yield matches the 12% market rate, yielding $1,080 after one year, which is the sum of the $80 interest and $1,000 principal repayment.