11 Solutions for Discussion Problems - Financial Liabilities 2021 (1)

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Solutions to Discussion Problems – Financial Liabilities Problem 3 Part a Required: 1. What is the issue price of each bond? A. $1,000,000 PV (10, 9%) + $100,000 PVA (10,9%) – this is the mathematical abbreviation. you can use the formula, a financial calculator or tables. I will provide tables with each exam. Calculator inputs – enter 1,000,000 and press FV, Then enter 100,000 and press PMT, Then 10 & press N, Then 9 & I/Y, Then press CPT, then PV = $1,064,176.58 B. $1,000,000 PV (10, 9%) + $80,000 PVA (10, 9%) = $935,823.42 Inputs: FV= 1,000,000, PMT = 80,000, I/Y = 9, N= 10 CPT PV = 935,823.42 C. $1,000,000 since coupon rate = market rate 2 . For each alternative, how much cash will the company pay out in the year 2022? A. $100,000 B. $80,000 C. $90,000 3. For each alternative, how much interest expense will the company record for the year ended December 31, 2022? Use the effective interest method. A. $1,064,176.58*9% = $95,775.89 B. $935,823.42*9% = $84,224.11 C. $1,000,000*9% = $90,000 4. For each alternative, how much interest expense will the company record over the entire 10-year life of the bond? A. 10 x $100,000 – ($1,064,176.58-$1,000,000) = $935,823.42 B. 10 x $80,000 + ($1,000,000-935,824) = $864,176.58 C. $900,000 1
Financial Liabilities, Problem 3 Amortization Tables – prepared in Excel Face Value $1,000,000 Effective Rate 9% Coupon rate a 10% Coupon rate b 8% Lumpsum, 9%, 10 years 0.422410807 Annuity, 9%, 10 years 6.417657701 Cash interest a $100,000 Cash interest b $80,000 Proceeds a $1,064,176.58 Proceeds b $935,823.42 Amortization Table a Interest Exp. Pymt. Amort. Liability $1,064,176.58 1 $95,775.89 $100,00 0 $4,224.11 $1,059,952.47 2 $95,395.72 $100,00 0 $4,604.28 $1,055,348.19 3 $94,981.34 $100,00 0 $5,018.66 $1,050,329.53 4 $94,529.66 $100,00 0 $5,470.34 $1,044,859.19 5 $94,037.33 $100,00 0 $5,962.67 $1,038,896.51 6 $93,500.69 $100,00 0 $6,499.31 $1,032,397.20 7 $92,915.75 $100,00 0 $7,084.25 $1,025,312.95 8 $92,278.17 $100,00 0 $7,721.83 $1,017,591.11 9 $91,583.20 $100,00 0 $8,416.80 $1,009,174.31 10 $90,825.69 $100,00 0 $9,174.31 $1,000,000.00 $935,823.42 Amortization Table b $935,823.42 1 $84,224.11 $80,000 $4,224.11 $940,047.53 2 $84,604.28 $80,000 $4,604.28 $944,651.81 3 $85,018.66 $80,000 $5,018.66 $949,670.47 4 $85,470.34 $80,000 $5,470.34 $955,140.81 5 $85,962.67 $80,000 $5,962.67 $961,103.49 6 $86,499.31 $80,000 $6,499.31 $967,602.80 2
7 $87,084.25 $80,000 $7,084.25 $974,687.05 8 $87,721.83 $80,000 $7,721.83 $982,408.89 9 $88,416.80 $80,000 $8,416.80 $990,825.69 10 $89,174.31 $80,000 $9,174.31 $1,000,000.00 $864,176.58 3
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Problem 3, continued Part B Now assume that Python chose Alternative A from Part A, issuing $1,000,000 10-year bonds with an annual coupon rate of 10% when the market rate was 9%. On December 31, 2022, Python undertakes a debt/equity swap. The market interest rate for bonds of the risk and duration of Python’s is 10% at the time of the swap. Python issues equity equal to the market value of the bonds at the swap date. Prior to recording the swap transaction, Python’s income was $1,000,000. Python had 1,000,000 shares outstanding during 2022. Analysts had predicted that Python’s 2022 earnings per share would be $1.05. Required: 1. Prepare the entry to record the swap transaction. (I rounded to the nearest $.) Bonds Payable 1,000,000 Premium on Bonds Payable* 59,953 Share capital 1,000,000 Gain on debt-for equity swap 59,953 Original premium $64,176.58 - ($100,000-$95,775.89)( payment – interest recorded) = $59,952.47 rounded to 59,953. 2. What is the advantage to Python of engaging in the swap transaction? Earnings per share prior to the swap is $1.00, which does not meet analysts’ expectation. Earnings per share after the swap is $1.06 ($1,059,953/1,000,000), exceeding analysts’ expectations by 1 cent. The swap induces a cosmetic increase in reported income. 4
Problem 4 1. What was the issue price of the bonds on January 1, 2018? $1,000,000 X 0.558395 + $70,000 X 7.360087 = $1,073,601 2. What was the carrying value of the bonds on the swap date 5 years left to maturity $1,000,000 X 0.747258 + $70,000 X 4.212364 = $1,042,123 3. What is the minimum value that the new equity issued in exchange for the bonds would need to be worth in order for bondholders to accept the swap? $1,000,000 (value of bonds on swap date) 4. Prepare the journal entry to record the swap transaction using the equity value you calculated in 3 above. Bonds Payable 1,000,000 Premium on bonds payable 42,123 Common Stock 1,000,000 Gain on swap 42,123 5. Calculate net income after the swap transaction, as well as the debt to equity ratio both before and after the swap transaction. Net Income Debt Equity Debt/equity Before $500,000 $2,000,000 $1,500,000 1.33 Effect of swap 42,123 (1,042,123) 1,042,123* After $542,123 $957,877 $2,542,123 0.38 * Note that the gain on the swap gets closed into Retained Earnings 5
6. Suggest one cosmetic reason, and one economic reason why Bondco may have engaged in the swap transaction. Clearly indicate which reason is cosmetic, and which economic. Cosmetic: Net income is increased. Note that the real economic gain took place when the interest rate rose, not when the swap transaction was recorded. Economic: The debt/equity ratio is decreased. 6
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