INIHAO, JANE CARMEL G.

GUMAPAC, IAN V.
CPA, MBA
CASE ON BONDS VALUATION

APRIL 30, 2016

MS. ESTELA S. GANAS,
MBA 114 B

Case of Joan Holtz (D)

Having recently studied liabilities and the concept of present value, Joan Holtz
was interested in discussing with the accounting professor several matters that had
recently come to Joans attention in the newspaper and on television. (Refer to the
case for the questions raised by Joan Holtz on each of the five issues)
1. The future value of $100 invested at 10 percent compound interest, 127
years (1879-2006) from now is $100 (1.10)127 = $18,066,000.
2. a. The yield was 15 percent and the present value is $327 [$1,000 x 0.327
(which derived from the Appendix Table A under 8 year, 15% PV)]
b. The discount is $1,000 327 = $673; using straight-line amortization, that
is $673 divided by 8 = $84.125/bond/yr., resulting in annual tax savings of
$84.125*0.40=$33.65. Thus, the bond issuer contemplates the following cash
flow pattern:
Time Zero + $327
Years 1-8
+ $33.65/yr.
End of year 8
- $1,000
c. With 15 percent bonds issued for par, the net-of-tax interest payment
stream is simply $150 (1-0.40) = $90/bond/yr. for 8 years. If calculated like in
b, but with Time Zero in flow equal to $1,000 (instead of $327) and the
annual outflows equal to $90 (instead of $33.65 annual inflows), the rate
giving an NPV of zero is 9.0 percent.
3. Refunding a bond issue is just a special case of early extinguishment: the
proceeds to retire the current debt come from a new debt issue. In the debtfor-equity swap were considering, the substance of the transaction is the
same as if the company issued shares and then used the cash proceeds to
buy its bonds on the open market; in effect, the company is simply paying an
investment banker to do this on the companys behalf. But in fact, a company
is motivated in the debt-for-equity swap to use the investment banker as an
intermediary because the tax laws are such that if the company handled the
transactions on its own, it would pay taxes on the difference between the
repurchase cost of the bonds and their balance sheet carrying value,
irrespective of the source of the funds used to repurchase the bonds.

Bonds Payable

Debit
72 million

Credit

Capital Stock
Retained Earnings

43 million
29 million

4. The Airlines were carrying a relatively small liability for earned but unused
frequent flier mileage credit. An alternative approach would require a revenue
deferral approach. A portion of revenue applicable to each original ticket
would be deferred until the free tickets expected to be awarded were issued
and used. The approach implies that when a traveller purchases a ticket, he
is also paying a portion of a free ticket he will earn in the future.
The amount of the revenue deferral has become a fuzzy issue especially
because the airline has started to make restrictions on when to use the free
tickets. An airline may argue that a free ticket will just be filling an otherwise
empty seat or that most free ticket is never claimed.
The FASB permits the use of either the cost reserve or revenue deferral
method.
5. The management must view the sales as a singles transaction so that the
Profitability of the extended warranties will increase the Margin of their
Product. Otherwise, they would not be willing to earn such a low margin on
the sale of the electronics product alone.
Alternative
Alternative A

Income Statement
Lowest Revenue and
Lowest net income

Alternative B

Highest revenue and

net income

Alternative C

Second highest
revenue and net
income

Balance Sheet
Smallest retained
earnings and largest
deferred revenue
liability
Largest retained
earnings and no
deferred revenue
liability
Second highest
retained earnings and
a deferred revenue
liability that will
increase each year.