Question

Hollingsworth Company issues 10%, 5-year bonds with a par value of $100,000, dated January 1, 2014. Interest is payable annually. At the time of issue, the market rate of interest was 12%.

a. Provide the journal entry for the date of issue, January 1, 2014.

Answer 1

Due to interest rates rising from 6% to 9%, the present value of the bond would be less than its face value of $10,000. To determine its value, one would discount the future cash flows of interest and face value at the 9% rate, leading to a purchase price lower than $10,000.

Step-by-step explanation:

The value of a bond is directly related to the market interest rates. If market interest rates rise, new bonds are issued with higher rates, making existing bonds with lower rates less attractive and worth less on the market. Conversely, if market rates fall, existing bonds with higher rates become more valuable.

For a $10,000 bond at a 6% interest rate, if market interest rates rise to 9%, you would expect to pay less than the bond's face value because it is paying an interest rate lower than the current market rate. To calculate what you might pay for the bond, you would discount the bond's future cash flows (interest payments and face value repayment) at the new market interest rate of 9%.

To determine the present value of the bond's payments, you would apply the present value formula to each payment and sum them:

The present value of the bond would be the sum of the present values of these two cash flows, which would be less than $10,000 given the increase in interest rates to 9%.