CHAPTER 15

BONDS PAYABLE AND

INVESTMENTS IN BONDS
QUESTION INFORMATION
Number Objective Description Difficulty Time AACSB AICPA
EO15-1 15-2 Easy 5 min Analytic FN-Measurement
EO15-2 15-2 Easy 5 min Analytic FN-Measurement
EO15-3 15-2 Easy 5 min Analytic FN-Measurement
EO15-4 15-2 Easy 5 min Analytic FN-Measurement
EO15-5 15-2 Easy 5 min Analytic FN-Measurement
EO15-6 15-2 Easy 5 min Analytic FN-Measurement
EO15-7 15-2 Easy 5 min Analytic FN-Measurement
EO15-8 15-2 Easy 5 min Analytic FN-Measurement
EO15-9 15-3 Easy 5 min Analytic FN-Measurement
EO15-10 15-3 Easy 5 min Analytic FN-Measurement
EO15-11 15-3 Easy 5 min Analytic FN-Measurement
EO15-12 15-3 Easy 5 min Analytic FN-Measurement
EO15-13 15-4 Easy 5 min Analytic FN-Measurement
EO15-14 15-5 Easy 5 min Analytic FN-Measurement
EO15-15 15-6 Easy 5 min Analytic FN-Measurement
PE15-1A 15-1 Determining the effect Easy 5 min Analytic FN-Measurement
of alternative financ-
ing plans on earnings
per share
PE15-1B 15-1 Determining the effect Easy 5 min Analytic FN-Measurement
of alternative financ-
ing plans on earnings
per share
PE15-2A 15-2 Determine the present Easy 5 min Analytic FN-Measurement
value of a future
amount
PE15-2B 15-2 Determine the present Easy 5 min Analytic FN-Measurement
value of a future
amount
PE15-3A 15-2 Determine the present Easy 5 min Analytic FN-Measurement
value of a bond
PE15-3B 15-2 Determine the present Easy 5 min Analytic FN-Measurement
value of a bond
PE15-4A 15-3 Record the issuance Easy 5 min Analytic FN-Measurement
of bonds payable
PE15-4B 15-3 Record the issuance Easy 5 min Analytic FN-Measurement
of bonds payable
PE15-5A 15-3 Record the interest for Easy 5 min Analytic FN-Measurement
bonds payable
PE15-5B 15-3 Record the interest for Easy 5 min Analytic FN-Measurement
bonds payable
PE15-6A 15-3 Record the issuance Easy 5 min Analytic FN-Measurement
of bonds payable
PE15-6B 15-3 Record the issuance Easy 5 min Analytic FN-Measurement
of bonds payable
PE15-7A 15-3 Record the interest for Easy 5 min Analytic FN-Measurement
bonds payable
PE15-7B 15-3 Record the interest for Easy 5 min Analytic FN-Measurement
bonds payable

811
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 Number Objective Description Difficulty Time AACSB AICPA
PE15-8A 15-4 Record the redemp- Easy 5 min Analytic FN-Measurement
tion of bonds payable
PE15-8B 15-4 Record the redemp- Easy 5 min Analytic FN-Measurement
tion of bonds payable
PE15-9A 15-5 Record the purchase Easy 5 min Analytic FN-Measurement
of a bond investment
PE15-9B 15-5 Record the purchase Easy 5 min Analytic FN-Measurement
of a bond investment
Ex15-1 15-1 Effect of financing on Easy 10 min Analytic FN-Measurement
earnings per share
Ex15-2 15-1 Evaluating alternative Easy 5 min Analytic FN-Measurement
financing plans
Ex15-3 15-1 Corporate financing Easy 5 min Analytic FN-Measurement
Ex15-4 15-2 Present value of Easy 10 min Analytic FN-Measurement
amounts due
Ex15-5 15-2 Present value of an Easy 10 min Analytic FN-Measurement
annuity
Ex15-6 15-2 Present value of an Easy 5 min Analytic FN-Measurement
annuity
Ex15-7 15-2 Present value of an Easy 5 min Analytic FN-Measurement
annuity
Ex15-8 15-2, 15-3 Present value of Easy 5 min Analytic FN-Measurement
bonds payable, dis-
count
Ex15-9 15-2, 15-3 Present value of Easy 5 min Analytic FN-Measurement
bonds payable, pre-
mium
Ex15-10 15-2, 15-3 Bond price Easy 5 min Analytic FN-Measurement
Ex15-11 15-3 Entries for issuing Easy 10 min Analytic FN-Measurement
bonds
Ex15-12 15-3 Entries for issuing Easy 15 min Analytic FN-Measurement
bonds and amortizing
discount by straight-
line method
Ex15-13 15-2, 15-3 Computing bond pro- Easy 10 min Analytic FN-Measurement
ceeds, entries for
bond issuing, and
amortizing premium
by straight-line
method
Ex15-14 15-3, 15-4 Entries for issuing and Easy 10 min Analytic FN-Measurement
calling bonds, loss
Ex15-15 15-3, 15-4 Entries for issuing and Easy 10 min Analytic FN-Measurement
calling bonds, gain
Ex15-16 15-4, 15-6 Reporting bonds Easy 5 min Analytic FN-Measurement
Ex15-17 15-5 Amortizing discount Easy 5 min Analytic FN-Measurement
on bond investment
Ex15-18 15-5 Entries to purchase Easy 10 min Analytic FN-Measurement
and sale of invest-
ments in bonds, loss
Ex15-19 15-5 Entries to purchase Easy 10 min Analytic FN-Measurement
and sale of invest-
ments in bonds, gain
Ex15-20 FAI Number of times in- Easy 10 min Analytic FN-Measurement
terest charges earned
Ex15-21 Appendix Amortize discount by Easy 15 min Analytic FN-Measurement
interest method

Ex15-22 Appendix Amortize premium by Moderate 15 min Analytic FN-Measurement

interest method

812
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 Number Objective Description Difficulty Time AACSB AICPA
Ex15-23 Appendix Computing bond pro- Moderate 15 min Analytic FN-Measurement
ceeds, amortizing
premium by interest
method, and interest
expense
Ex15-24 Appendix Compute bond pro- Moderate 15 min Analytic FN-Measurement
ceeds, amortizing
discount by interest
method, and interest
expense
Pr15-1A 15-1 Effects of financing on Moderate 1 1/2 Analytic FN-Measurement
earnings per share hr
Pr15-2A 15-2, 15-3 Present value, bond Moderate 1 hr Analytic FN-Measurement
premium, entries for
bonds payable trans-
actions
Pr15-3A 15-2, 15-3 Present value, bond Moderate 1 hr Analytic FN-Measurement
discount, entries for
bonds payable trans-
actions
Pr15-4A 15-3, 15-4 Entries for bonds Moderate 1 hr Analytic FN-Measurement
payable transactions
Pr15-5A 15-5 Entries for bond in- Moderate 1 1/4 Analytic FN-Measurement
vestments hr
Pr15-6A Appendix Entries for bonds Moderate 45 min Analytic FN-Measurement
payable transactions,
interest method of
amortizing bond pre-
mium
Pr15-7A Appendix Entries for bonds Moderate 45 min Analytic FN-Measurement
payable transactions,
interest method of
amortizing bond dis-
count
Pr15-1B 15-1 Effects of financing on Moderate 1 1/2 Analytic FN-Measurement
earnings per share hr
Pr15-2B 15-2, 15-3 Present value, bond Moderate 1 hr Analytic FN-Measurement
premium, entries for
bonds payable trans-
actions
Pr15-3B 15-2, 15-3 Present value, bond Moderate 1 hr Analytic FN-Measurement
discount, entries for
bonds payable trans-
actions
Pr15-4B 15-3, 15-4 Entries for bonds Moderate 1 hr Analytic FN-Measurement
payable transactions
Pr15-5B 15-5 Entries for bond in- Moderate 1 1/4 Analytic FN-Measurement
vestments hr
Pr15-6B Appendix Entries for bonds Moderate 45 min Analytic FN-Measurement
payable transactions,
interest method of
amortizing bond pre-
mium
Pr15-7B Appendix Entries for bonds Moderate 45 min Analytic FN-Measurement
payable transactions,
interest method of
amortizing bond dis-
count

813
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resold, copied, or distributed without the prior consent of the publisher.
 Number Objective Description Difficulty Time AACSB AICPA
Comp 15-1, 15-2, Journalize transac- Difficult 3 hr Analytic FN-Measurement
Problem 4 15-2, 15-4, tions, prepare finan-
15-5, 15-6 cial statements
SA15-1 15-2 General Electric bond Easy 5 min Ethics BB-Industry
issuance
SA15-2 15-2 Ethics and profes- Easy 5 min Ethics BB-Industry
sional conduct in
business
SA15-3 15-2 Present values Easy 10 min Analytic FN-Measurement
SA15-4 15-1 Preferred stock vs. Easy 5 min Analytic FN-Measurement
bonds
SA15-5 15-2, 15-3 Investing in bonds Moderate 15 min Analytic FN-Measurement
SA15-6 15-1 Investing in bonds Easy 20 min Analytic FN-Measurement
SA15-7 15-2 Financing business Moderate 30 min Analytic FN-Measurement
expansion

814
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 EYE OPENERS
1. (1) To pay the face (maturity) amount of the
bonds at a specified date. (2) To pay peri-
odic interest at a specified percentage of the
face amount.
2. a. Bonds that may be exchanged for other
securities under specified conditions.
b. The issuing corporation reserves the
right to redeem the bonds before the
maturity date.
c. Bonds issued on the basis of the gen-
eral credit of the corporation.
3. The phrase time value of money means
that an amount of cash to be received today
is worth more than the same amount of cash
to be received in the future. This is because
cash on hand today can be invested to earn
income.
4. (b) $9,000 to be received at the end of each
of the next two years has the higher present
value because cash that is received earlier
can be invested to earn income.
5. Less than face amount. Because compara-
ble investments in bonds provide a market
interest rate (10%) that is greater than the
rate on the bond being purchased (9%), the
bond will sell at a discount as the markets
means of equalizing the two interest rates.
6. a. Greater than $5,000,000
b. 1. $5,000,000
2. 5%
3. 7%
4. $5,000,000
815
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7. Less than the contract rate
8. a. Premium
b. $125,000
c. Premium on Bonds Payable
9. a. Debit Interest Expense
Credit Discount on Bonds Payable
b. Debit Premium on Bonds Payable
Credit Interest Expense
10. No. Because zero-coupon bonds do not
provide for interest payments, they will sell
at a discount.
11. The purpose of a bond sinking fund is to
accumulate over the life of a bond issue
enough funds to pay the indebtedness at the
maturity date.
12. The bond issue that is callable is more risky
for investors, because the company may re-
deem (call) the bond issue if interest rates
fall. In addition, since the bonds may be
called at their face amount, they will sell for
a lower value than the noncallable bond is-
sue.
13. A loss of $7,000 [($500,000 0.97)
($500,000 $22,000)]
14. Under the caption Investments
15. At their cost less any amortized premium or
plus any amortized discount
 PRACTICE EXERCISES

PE 151A

Plan 1 Plan 2
Earnings before bond interest and income tax ............... $400,000 $400,000
Bond interest ...................................................................... 120,0001 60,0003
Balance ............................................................................... $280,000 $340,000
Income tax .......................................................................... 112,0002 136,0004
Net income.......................................................................... $168,000 $204,000
Dividends on preferred stock............................................ 0 140,000
Earnings available for common stock.............................. $168,000 $ 64,000
Number of common shares............................................... /100,000 / 80,000
Earnings per share on common stock ............................. $ 1.68 $ 0.80
1
$1,000,000 12%
2
$280,000 40%
3
$500,000 12%
4
$340,000 40%

PE 151B

Plan 1 Plan 2
Earnings before bond interest and income tax ............... $ 500,000 $ 500,000
Bond interest ...................................................................... 270,0001 216,0003
Balance .............................................................................. $ 230,000 $ 284,000
Income tax .......................................................................... 92,0002 113,6004
Net income.......................................................................... $ 138,000 $ 170,400
Dividends on preferred stock............................................ 0 120,000
Earnings available for common stock.............................. $ 138,000 $ 50,400
Number of common shares............................................... / 150,000 / 120,000
Earnings per share on common stock ............................. $ 0.92 $ 0.42
1
$3,000,000 9%
2
$230,000 40%
3
$2,400,000 9%
4
$284,000 40%

PE 152A

$3,558.45. [$7,000 0.50835 (Present value of $1 for 10 periods at 7%)]

816
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PE 152B

$1,357.05. [$3,000 0.45235 (Present value of $1 for 7 periods at 12%)]

PE 153A

Present value of face amount of $150,000 due in 10 years,

at 7% compounded annually: $150,000 0.50835
(present value factor of $1 for 10 periods at 7%) .................... $ 76,252*
Present value of 10 annual interest payments of $10,500,
at 7% interest compounded annually:
$10,500 7.02358 (present value of annuity of $1
for 10 periods at 7%).................................................................. 73,748
Total present value of bonds $150,000
*Rounded to the nearest dollar.

PE 153B

Present value of face value of $80,000 due in 5 years,

at 10% compounded annually: $80,000 0.62092
(present value factor of $1 for 5 periods at 10%) .................... $ 49,674*
Present value of 5 annual interest payments of $8,000,
at 10% interest compounded annually: $8,000 3.79079
(present value of annuity of $1 for 5 periods at 10%) ............. 30,326*
Total present value of bonds ......................................................... $ 80,000
*Rounded to the nearest dollar.

PE 154A

Cash ...................................................................................... 463,202

Discount on Bonds Payable ................................................ 36,798
Bonds Payable ................................................................ 500,000

PE 154B

Cash ...................................................................................... 1,330,403

Discount on Bonds Payable ................................................ 169,597
Bonds Payable ................................................................ 1,500,000

817
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PE 155A

Interest Expense................................................................... 26,840

Discount on Bonds Payable........................................... 1,840
Cash ................................................................................. 25,000
Paid interest and amortized the bond discount
($36,798/20).

PE 155B

Interest Expense................................................................... 76,960

Discount on Bonds Payable........................................... 16,960
Cash ................................................................................. 60,000
Paid interest and amortized the bond discount
($169,597/10).

PE 156A

Cash ...................................................................................... 2,154,429

Premium on Bonds Payable........................................... 154,429
Bonds Payable ................................................................ 2,000,000

PE 156B

Cash ...................................................................................... 1,065,040

Premium on Bonds Payable........................................... 65,040
Bonds Payable ................................................................ 1,000,000

PE 157A

Interest Expense................................................................... 104,557

Premium on Bonds Payable ................................................ 15,443
Cash ................................................................................. 120,000
Paid interest and amortized the bond premium
($154,429/10).

818
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resold, copied, or distributed without the prior consent of the publisher.
PE 157B

Interest Expense...................................................................... 46,748

Premium on Bonds Payable ................................................... 3,252
Cash .................................................................................... 50,000
Paid interest and amortized the bond premium
($65,040/20).

PE 158A

Bonds Payable......................................................................... 700,000

Loss on Redemption of Bonds .............................................. 45,000
Discount on Bonds Payable.............................................. 60,000
Cash .................................................................................... 685,000

PE 158B

Bonds Payable......................................................................... 250,000

Premium on Bonds Payable ................................................... 20,000
Gain on Redemption of Bonds ......................................... 25,000
Cash .................................................................................... 245,000

PE 159A

a. 2008
Sept. 1 Investment in Maxtech Corporation Bonds ... 56,000
Interest Revenue............................................... 1,400
Cash ............................................................. 57,400
b. 2008
Dec. 31 Investment in Maxtech Corporation Bonds ... 505*
Interest Revenue ......................................... 505
*[($70,000 $56,000)/111 months] 4 months.

819
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PE 159B

a. 2008
Mar. 1 Investment in PUA-Tech Corporation Bonds.... 40,000
Interest Revenue.................................................. 1,250
Cash ................................................................ 41,250
b. 2008
Dec. 31 Investment in PUA-Tech Corporation Bonds.... 901*
Interest Revenue ............................................ 901
*[($50,000 $40,000)/111 months] 10 months.

820
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 EXERCISES

Ex. 151

Bliss
Co.
a. Earnings before bond interest and income tax........... $ 1,000,000
Bond interest ................................................................. 240,000
Balance........................................................................... $ 760,000
Income tax...................................................................... 304,000
Net income ..................................................................... $ 456,000
Dividends on preferred stock ....................................... 320,000
Earnings available for common stock ......................... $ 136,000
Earnings per share on common stock......................... $ 0.68
b. Earnings before bond interest and income tax........... $ 1,800,000
Bond interest ................................................................. 240,000
Balance........................................................................... $ 1,560,000
Income tax...................................................................... 624,000
Net income ..................................................................... $ 936,000
Dividends on preferred stock ....................................... 320,000
Earnings available for common stock ......................... $ 616,000
Earnings per share on common stock......................... $ 3.08
c. Earnings before bond interest and income tax........... $ 3,200,000
Bond interest ................................................................. 240,000
Balance........................................................................... $ 2,960,000
Income tax...................................................................... 1,184,000
Net income ..................................................................... $ 1,776,000
Dividends on preferred stock ....................................... 320,000
Earnings available for common stock ......................... $ 1,456,000
Earnings per share on common stock......................... $ 7.28

Ex. 152

Factors other than earnings per share that should be considered in evaluating fi-
nancing plans include: bonds represent a fixed annual interest requirement, while
dividends on stock do not; bonds require the repayment of principal, while stock
does not; and common stock represents a voting interest in the ownership of the
corporation, while bonds do not.

821
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Ex. 153

Williams-Sonomas major source of financing is common stock. It has long-term

debt, excluding current installments, of $14,490,000, compared to stockholders
equity of $1,125,318,000.

Ex. 154

a. $200,000/1.07 = $186,916
$186,916/1.07 = $174,688
$174,688/1.07 = $163,260

b. $200,000 0.81630 = $163,260

Ex. 155

a. First Year: $75,000 0.95238 = $ 71,428.50

Second Year: $75,000 0.90703 = 68,027.25
Third Year: $75,000 0.86384 = 64,788.00
Fourth Year: $75,000 0.82270 = 61,702.50
Total present value $265,946.25

b. $75,000 3.54595 = $265,946.25

Ex. 156

$2,000,000 12.46221 = $24,924,420

Ex. 157

No. The present value of your winnings using an interest rate of 10% is
$17,027,120 ($2,000,000 8.51356), which is more than one-half of the present
value of your winnings using an interest rate of 5% ($24,924,420; see Ex. 156).
This is because of the effect of compounding the interest. That is, compound in-
terest functions are not linear functions, but use exponents.

822
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Ex. 158

Present value of $1 for 10 (semiannual)

periods at 5% (semiannual rate) .......................... 0.61391
Face amount of bonds ............................................... $20,000,000 $ 12,278,200
Present value of an annuity of $1
for 10 periods at 5%.............................................. 7.72174
Semiannual interest payment ................................... $900,000 6,949,566
Total present value (proceeds) ................................. $ 19,227,766

Ex. 159

Present value of $1 for 10 (semiannual)

periods at 5.5% (semiannual rate) ....................... 0.58543
Face amount of bonds ............................................... $15,000,000 $ 8,781,450
Present value of an annuity of $1
for 10 periods at 5.5%........................................... 7.53763
Semiannual interest payment ................................... $900,000 6,783,867
Total present value (proceeds) ................................. $ 15,565,317

Ex. 1510

The bonds were selling at a premium. This is indicated by the selling price of
108.89, which is stated as a percentage of face amount and is more than par
(100%). The market rate of interest for similar quality bonds was lower than
6.375%, and this is why the bonds were selling at a premium.

Ex. 1511

May 1 Cash ..................................................................... 12,000,000

Bonds Payable ................................................ 12,000,000
Nov. 1 Interest Expense ................................................. 480,000
Cash ................................................................. 480,000
Dec. 31 Interest Expense ................................................. 160,000*
Interest Payable .............................................. 160,000
*12,000,000 8% 2/12.

823
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Ex. 1512

a. 1. Cash .......................................................................... 11,116,854

Discount on Bonds Payable.................................... 883,146
Bonds Payable .................................................... 12,000,000
2. Interest Expense ...................................................... 600,000
Cash ..................................................................... 600,000
3. Interest Expense ...................................................... 600,000
Cash ..................................................................... 600,000
4. Interest Expense ...................................................... 176,629
Discount on Bonds Payable............................... 176,629
$883,146/5 years = $176,629.

b. Annual interest paid ...................................................... $1,200,000

Plus discount amortized ............................................... 176,629
Interest expense for first year ...................................... $1,376,629
Note: The following data in support of the proceeds of the bond issue stated
in the exercise are presented for the instructors information. Students are
not required to make the computations.
Present value of $1 for 10 (semiannual)
periods at 6% (semiannual rate)......................... 0.55840
Face amount ........................................................ $12,000,000 $ 6,700,800
Present value of annuity of $1 for 10
periods at 6% ....................................................... 7.36009
Semiannual interest payment............................. $600,000 4,416,054
Total present value of bonds payable................ $11,116,854

824
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Ex. 1513

a. Cash........................................................................... 4,301,504
Premium on Bonds Payable............................... 301,504
Bonds Payable .................................................... 4,000,000
Note: The following data are in support of the determination of the proceeds
of the bond issue stated in the exercise:
Present value of $1 for 10 (semiannual)
periods at 5.5% (semiannual rate) ..................... 0.58543
Face amount ............................................................. $4,000,000 $ 2,341,720
Present value of an annuity of $1 for 10
periods at 5.5%.................................................... 7.53763
Semiannual interest payment.................................. $260,000 1,959,784
Proceeds ................................................................... $ 4,301,504

b. Interest Expense....................................................... 229,850

Premium on Bonds Payable .................................... 30,150*
Cash ..................................................................... 260,000**
*$301,504/10 semiannual payments.
**$4,000,000 13% 6/12.

Ex. 1514

2008
Apr. 1 Cash ..................................................................... 7,000,000
Bonds Payable ................................................ 7,000,000
Oct. 1 Interest Expense ................................................. 315,000
Cash ................................................................. 315,000
2012
Oct. 1 Bonds Payable .................................................... 7,000,000
Loss on Redemption of Bonds .......................... 210,000
Cash ................................................................. 7,210,000

825
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Ex. 1515

2008
Jan. 1 Cash ..................................................................... 4,000,000
Bonds Payable ................................................ 4,000,000
July 1 Interest Expense ................................................. 140,000
Cash ................................................................. 140,000
2014
July 1 Bonds Payable .................................................... 4,000,000
Gain on Redemption of Bonds ...................... 160,000
Cash ................................................................. 3,840,000

Ex. 1516

1. The significant loss on redemption of the series X bonds should be reported

in the Other Income and Expense section of the income statement, rather
than as an extraordinary loss.

2. The series Y bonds outstanding at the end of the current year should be re-
ported as a noncurrent liability on the balance sheet because they are to be
paid from funds set aside in a sinking fund.

Ex. 1517

The discount of $4,180 ($5,000 $820) is amortized as interest revenue over the
life of the bonds, using the straight-line method (illustrated in this chapter) or the
interest method (illustrated in the appendix to this chapter).

826
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Ex. 1518

a. Investment in Sanhueza Co. Bonds ............................. 612,000

Interest Revenue............................................................ 10,500
Cash .......................................................................... 622,500
b. Cash................................................................................ 21,000
Interest Revenue ...................................................... 21,000
c. Interest Revenue............................................................ 960
Investment in Sanhueza Co. Bonds........................ 960
d. Cash................................................................................ 591,500
Loss on Sale of Investments ........................................ 18,720
Investment in Sanhueza Co. Bonds........................ 606,720
Interest Revenue ...................................................... 3,500

Ex. 1519

a. Investment in Blaga Co. Bonds.................................... 436,500

Interest Revenue............................................................ 9,000
Cash .......................................................................... 445,500
b. Cash................................................................................ 18,000
Interest Revenue ...................................................... 18,000
c. Investment in Blaga Co. Bonds.................................... 1,080
Interest Revenue ...................................................... 1,080
d. Cash................................................................................ 457,500
Investment in Blaga Co. Bonds .............................. 442,440
Gain on Sale of Investments ................................... 12,060
Interest Revenue ...................................................... 3,000

Ex. 1520

a. Current year:
$489,000,0 00 + $88,000,00 0
Number of times interest charges earned: 6.6 =
$88,000,00 0

Preceding year:
$708,000,0 00 + $91,000,00 0
Number of times interest charges earned: 8.8 =
$91,000,00 0

b. The number of times interest charges earned has declined from 8.8 to 6.6 in
the current year. Although Southwest Airlines has adequate earnings to pay
interest, the decline in this ratio may cause concern among debtholders.

827
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Appendix Ex. 1521

a. 1. Cash .......................................................................... 9,785,645

Discount on Bonds Payable.................................... 1,214,355
Bonds Payable .................................................... 11,000,000
2. Interest Expense ...................................................... 495,000
Cash ..................................................................... 495,000
3. Interest Expense ...................................................... 495,000
Cash ..................................................................... 495,000
4. Interest Expense ...................................................... 189,806
Discount on Bonds Payable............................... 189,806
Computations:
$9,785,645 6% = $587,139
$587,139 $495,000 = $92,139 first semiannual amortization
$9,785,645 + $92,139 = $9,877,784
$9,877,784 6% = $592,667
$592,667 $495,000 = $97,667 second semiannual amortization
$92,139 + $97,667 = $189,806 amortization for first year
Note: The following data in support of the proceeds of the bond issue stated
in the exercise are presented for the instructors information. Students are
not required to make the computations.
Present value of $1 for 10 (semiannual)
periods at 6% (semiannual rate) ........................ 0.55840
Face amount ............................................................. $11,000,000 $ 6,142,400
Present value of annuity of $1 for
10 periods at 6%.................................................. 7.36009
Semiannual interest payment.................................. $495,000 3,643,245
Total present value of bonds payable..................... $ 9,785,645

b. Annual interest paid ...................................................... $ 990,000

Plus discount amortized ............................................... 189,806
Interest expense for first year ...................................... $ 1,179,806

828
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Appendix Ex. 1522

a. 1. Cash .......................................................................... 2,688,440

Premium on Bonds Payable .............................. 188,440
Bonds Payable .................................................... 2,500,000
2. Interest Expense ...................................................... 162,500
Cash ..................................................................... 162,500
3. Interest Expense ...................................................... 162,500
Cash ..................................................................... 162,500
4. Premium on Bonds Payable.................................... 30,077
Interest Expense ................................................. 30,077
Computations:
$2,688,440 5.5% = $147,864
$162,500 $147,864 = $14,636 first semiannual amortization
$2,688,440 $14,636 = $2,673,804
$2,673,804 5.5% = $147,059
$162,500 $147,059 = $15,441 second semiannual amortization
$14,636 + $15,441 = $30,077 first year amortization
b. Annual interest paid ...................................................... $325,000
Less premium amortized .............................................. 30,077
Interest expense for first year ...................................... $294,923

829
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Appendix Ex. 1523

a. Present value of $1 for 10 (semiannual)

periods at 5.5% (semiannual rate) ..................... 0.58543
Face amount ............................................................. $22,000,000 $12,879,460
Present value of annuity of $1 for 10
periods at 5.5%.................................................... 7.53763
Semiannual interest payment.................................. $1,540,000 11,607,950
Proceeds of bond sale ............................................. $24,487,410
b. First semiannual interest payment ......................... $ 1,540,000
5.5% of carrying amount of $24,487,410................. 1,346,808
Premium amortized .................................................. $ 193,192
c. Second semiannual interest payment .................... $ 1,540,000
5.5% of carrying amount of $24,294,218* ............... 1,336,182
Premium amortized .................................................. $ 203,818
*$24,487,410 $193,192 = $24,294,218
d. Annual interest paid ................................................. $ 3,080,000
Less premium amortized ......................................... 397,010*
Interest expense for first year ................................. $ 2,682,990
*$193,192 + $203,818 = $397,010.

830
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Appendix Ex. 1524

a. Present value of $1 for 10 (semiannual)

periods at 5% (semiannual rate) ........................ 0.61391
Face amount ............................................................. $27,500,000 $16,882,525
Present value of annuity of $1 for 10 periods at 5%... 7.72174
Semiannual interest payment.................................. $1,100,000 8,493,914
Proceeds of bond sale ............................................. $25,376,439
b. 5% of carrying amount of $25,376,439.................... $ 1,268,822
First semiannual interest payment ......................... 1,100,000
Discount amortized .................................................. $ 168,822
c. 5% of carrying amount of $25,545,261* .................. $ 1,277,263
Second semiannual interest payment .................... 1,100,000
Discount amortized .................................................. $ 177,263
*$25,376,439 + $168,822 = $25,545,261.
d. Annual interest paid ................................................. $ 2,200,000
Plus discount amortized .......................................... 346,085*
Interest expense first year ....................................... $ 2,546,085
*$168,822 + $177,263 = $346,085.

831
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 PROBLEMS

Prob. 151A

1. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $20,000,000 $20,000,000 $20,000,000
Deduct interest on bonds ............................... 1,600,000
Income before income tax .............................. $20,000,000 $20,000,000 $18,400,000
Deduct income tax .......................................... 8,000,000 8,000,000 7,360,000
Net income....................................................... $12,000,000 $12,000,000 $11,040,000
Dividends on preferred stock......................... 800,000 400,000
Available for dividends on common stock ... $12,000,000 $11,200,000 $10,640,000
Shares of common stock outstanding .......... / 4,000,000 / 2,000,000 / 1,000,000
Earnings per share on common stock .......... $ 3.00 $ 5.60 $ 10.64

2. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $ 2,600,000 $ 2,600,000 $ 2,600,000
Deduct interest on bonds ............................... 1,600,000
Income before income tax .............................. $ 2,600,000 $ 2,600,000 $ 1,000,000
Deduct income tax .......................................... 1,040,000 1,040,000 400,000
Net income....................................................... $ 1,560,000 $ 1,560,000 $ 600,000
Dividends on preferred stock......................... 800,000 400,000
Available for dividends on common stock ... $ 1,560,000 $ 760,000 $ 200,000
Shares of common stock outstanding .......... / 4,000,000 / 2,000,000 / 1,000,000
Earnings per share on common stock .......... $ 0.39 $ 0.38 $ 0.20

832
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Prob. 151A Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of com-
mon stock, which does not require a periodic interest payment or return of
principal, and a payment of preferred dividends is not required. It is also more
attractive to common shareholders than is Plan 2 or 3 if earnings before in-
terest and income tax is $2,600,000. In this case, it has the largest EPS
($0.39). The principal disadvantage of Plan 1 is that it requires an additional
investment by present common shareholders to retain their current interest in
the company. Also, if earnings before interest and income tax is $20,000,000,
this plan offers the lowest EPS ($3.00) on common stock.

The principal advantage of Plan 3 is that little additional investment would

need to be made by common shareholders for them to retain their current
interest in the company. Also, it offers the largest EPS ($10.64) if earnings
before interest and income tax is $20,000,000. Its principal disadvantage is
that the bonds carry a fixed annual interest charge and require the payment of
principal. It also requires a dividend payment to preferred stockholders be-
fore a common dividend can be paid. Finally, Plan 3 provides the lowest EPS
($0.20) if earnings before interest and income tax is $2,600,000.

Plan 2 provides a middle ground in terms of the advantages and disadvan-

tages described in the preceding paragraphs for Plans 1 and 3.

833
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Prob. 152A

1. Cash........................................................................ 844,077*
Premium on Bonds Payable............................ 44,077
Bonds Payable ................................................. 800,000
*Present value of $1 for 20 (semiannual)
periods at 6.5% (semiannual rate) .................. 0.28380
Face amount .......................................................... $800,000 $227,040
Present value of an annuity of $1 for 20
periods at 6.5%................................................. 11.01851
Semiannual interest payment............................... $56,000 617,037
Proceeds of bond issue ........................................ $844,077

2. a. Interest Expense ................................................. 53,796

Premium on Bonds Payable ($44,077/20).......... 2,204
Cash ................................................................ 56,000
b. Interest Expense ................................................. 53,796
Premium on Bonds Payable............................... 2,204
Cash ................................................................ 56,000

3. $53,796

4. Yes. Investors will be willing to pay more than the face amount of the bonds
when the interest payments they will receive from the bonds exceed the
amount of interest that they could receive from investing in other bonds.

834
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Prob. 153A

1. Cash........................................................................... 11,783,070*
Discount on Bonds Payable .................................... 716,930
Bonds Payable .................................................... 12,500,000
*Present value of $1 for 20 (semiannual)
periods at 6% (semiannual rate) ........................ 0.31180
Face amount ............................................................. $12,500,000 $ 3,897,500
Present value of an annuity of $1 for 20
periods at 6%....................................................... 11.46992
Semiannual interest payment.................................. $687,500 7,885,570
Proceeds of bond issue ........................................... $ 11,783,070

2. a. Interest Expense ................................................. 723,347

Discount on Bonds Payable
($716,930/20) .................................................. 35,847
Cash ................................................................ 687,500
b. Interest Expense ................................................. 723,347
Discount on Bonds Payable.......................... 35,847
Cash ................................................................ 687,500

3. $723,347

4. Yes. Investors will not be willing to pay the face amount of the bonds when
the interest payments they will receive from the bonds are less than the
amount of interest that they could receive from investing in other bonds.

835
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Prob. 154A

1.
2007
July 1 Cash .............................................................. 20,880,780
Premium on Bonds Payable .................. 1,880,780
Bonds Payable ........................................ 19,000,000
Dec. 31 Interest Expense .......................................... 1,140,000
Cash ......................................................... 1,140,000
31 Premium on Bonds Payable........................ 134,341
Interest Expense ..................................... 134,341
31 Income Summary ......................................... 1,005,659
Interest Expense ..................................... 1,005,659
2008
June 30 Interest Expense .......................................... 1,140,000
Cash ......................................................... 1,140,000
Dec. 31 Interest Expense .......................................... 1,140,000
Cash ......................................................... 1,140,000
31 Premium on Bonds Payable........................ 268,682
Interest Expense ..................................... 268,682
31 Income Summary ......................................... 2,011,318
Interest Expense ..................................... 2,011,318
2009
July 1 Bonds Payable ............................................. 19,000,000
Premium on Bonds Payable........................ 1,343,416
Gain on Redemption on Bonds ............. 1,058,416
Cash ($19,000,000 101.5%).................. 19,285,000

2. a. 2007: $1,005,659
b. 2008: $2,011,318

3. Initial carrying amount of bonds .................................. $20,880,780

Premium amortized on December 31, 2007................. (134,341)
Premium amortized on December 31, 2008................. (268,682)
Carrying amount of bonds, December 31, 2008.......... $20,477,757

836
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Prob. 155A

2007
Sept. 1 Investment in Wilson Company Bonds............. 578,580
Interest Revenue ($600,000 10% 2/12) ........ 10,000
Cash ................................................................. 588,580
Dec. 31 Cash ..................................................................... 30,000
Interest Revenue ............................................. 30,000
31 Investment in Wilson Company Bonds............. 360*
Interest Revenue ............................................. 360
*[($600,000 $578,580)/238 months]x4.
2012
June 30 Cash ..................................................................... 30,000
Interest Revenue ............................................. 30,000
Oct. 31 Investment in Wilson Company Bonds............. 450
Interest Revenue ............................................. 450
31 Cash ..................................................................... 300,600*
Loss on Sale of Investments ............................. 1,480
Investment in Wilson Company Bonds......... 292,080
Interest Revenue ............................................. 10,000
*($300,000 0.97) + ($300,000 10% 4/12) $400
Dec. 31 Cash ..................................................................... 15,000
Interest Revenue ............................................. 15,000
31 Investment in Wilson Company Bonds............. 540
Interest Revenue ............................................. 540

837
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Appendix Prob. 156A

1. a. Interest Expense ...................................................... 54,865

Premium on Bonds Payable
[$56,000 (6.5% $844,077)] .................................. 1,135
Cash ..................................................................... 56,000
b. Interest Expense ...................................................... 54,791
Premium on Bonds Payable
[$56,000 (6.5% $842,942)] .................................. 1,209
Cash ..................................................................... 56,000

2. $54,865

Appendix Prob. 157A

1. a. Interest Expense ...................................................... 706,984

Discount on Bonds Payable
[($687,500 (6% $11,783,070)]........................ 19,484
Cash ..................................................................... 687,500
b. Interest Expense ...................................................... 708,153
Discount on Bonds Payable
[$687,500 (6% $11,802,554)] ......................... 20,653
Cash ..................................................................... 687,500

2. $706,984

838
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Prob. 151B

1. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $30,000,000 $30,000,000 $30,000,000
Deduct interest on bonds ............................... 1,200,000
Income before income tax .............................. $30,000,000 $30,000,000 $28,800,000
Deduct income tax .......................................... 12,000,000 12,000,000 11,520,000
Net income....................................................... $18,000,000 $18,000,000 $17,280,000
Dividends on preferred stock......................... 600,000 300,000
Available for dividends on common stock ... $18,000,000 $17,400,000 $16,980,000
Shares of common stock outstanding .......... / 7,500,000 / 3,750,000 / 1,875,000
Earnings per share on common stock .......... $ 2.40 $ 4.64 $ 9.06

2. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $ 1,800,000 $ 1,800,000 $ 1,800,000
Deduct interest on bonds ............................... 1,200,000
Income before income tax .............................. $ 1,800,000 $ 1,800,000 $ 600,000
Deduct income tax .......................................... 720,000 720,000 240,000
Net income....................................................... $ 1,080,000 $ 1,080,000 $ 360,000
Dividends on preferred stock......................... 600,000 300,000
Available for dividends on common stock ... $ 1,080,000 $ 480,000 $ 60,000
Shares of common stock outstanding .......... / 7,500,000 / 3,750,000 / 1,875,000
Earnings per share on common stock .......... $ 0.14 $ 0.13 $ 0.03

839
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Prob. 151B Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of com-
mon stock, which does not require a periodic interest payment or return of
principal, and a payment of preferred dividends is not required. It is also more
attractive to common shareholders than is Plan 2 or 3 if earnings before in-
terest and income tax is $1,800,000. In this case, it has the largest EPS
($0.14). The principal disadvantage of Plan 1 is that it requires an additional
investment by present common shareholders to retain their current interest in
the company. Also, if earnings before interest and income tax is $30,000,000,
this plan offers the lowest EPS ($2.40) on common stock.

The principal advantage of Plan 3 is that little additional investment would

need to be made by common shareholders for them to retain their current in-
terest in the company. Also, it offers the largest EPS ($9.06) if earnings before
interest and income tax is $30,000,000. Its principal disadvantage is that the
bonds carry a fixed annual interest charge and require the payment of princi-
pal. It also requires a dividend payment to preferred stockholders before a
common dividend can be paid. Finally, Plan 3 provides the lowest EPS ($0.03)
if earnings before interest and income tax is $1,800,000.

Plan 2 provides a middle ground in terms of the advantages and disadvan-

tages described in the preceding paragraphs for Plans 1 and 3.

840
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resold, copied, or distributed without the prior consent of the publisher.
Prob. 152B

1. Cash........................................................................... 18,375,706*
Premium on Bonds Payable............................... 2,375,706
Bonds Payable .................................................... 16,000,000
*Present value of $1 for 14 (semiannual)
periods at 5% (semiannual rate) ........................ 0.50507
Face amount ............................................................. $16,000,000 $ 8,081,120
Present value of an annuity of $1 for 14
periods at 5%....................................................... 9.89864
Semiannual interest payment.................................. $1,040,000 10,294,586
Proceeds of bond issue ........................................... $ 18,375,706

2. a. Interest Expense ................................................. 870,307

Premium on Bonds Payable ($2,375,706/14)..... 169,693
Cash ................................................................ 1,040,000
b. Interest Expense ................................................. 870,307
Premium on Bonds Payable............................... 169,693
Cash ................................................................ 1,040,000

3. $870,307

4. Yes. Investors will be willing to pay more than the face amount of the bonds
when the interest payments they will receive from the bonds exceed the
amount of interest that they could receive from investing in other bonds.

841
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resold, copied, or distributed without the prior consent of the publisher.
Prob. 153B

1. Cash........................................................................... 20,344,863*
Discount on Bonds Payable .................................... 1,655,137
Bonds Payable .................................................... 22,000,000
*Present value of $1 for 40 (semiannual)
periods at 6% (semiannual rate) ........................ 0.09722
Face amount ............................................................. $22,000,000 $ 2,138,840
Present value of an annuity of $1 for 40
periods at 6%....................................................... 15.04630
Semiannual interest payment.................................. $1,210,000 18,206,023
$20,344,863

2. a. Interest Expense ................................................. 1,251,378

Discount on Bonds Payable
($1,655,137/40) ............................................... 41,378
Cash ................................................................ 1,210,000
b. Interest Expense ................................................. 1,251,378
Discount on Bonds Payable.......................... 41,378
Cash ................................................................ 1,210,000

3. $1,251,378

4. Yes. Investors will not be willing to pay the face amount of the bonds when
the interest payments they will receive from the bonds are less than the
amount of interest that they could receive from investing in other bonds.

842
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resold, copied, or distributed without the prior consent of the publisher.
Prob. 154B

1.
2007
July 1 Cash .............................................................. 11,252,273
Discount on Bonds Payable........................ 747,727
Bonds Payable ........................................ 12,000,000
Dec. 31 Interest Expense .......................................... 540,000
Cash ......................................................... 540,000
31 Interest Expense .......................................... 37,386
Discount on Bonds Payable .................. 37,386
31 Income Summary ......................................... 577,386
Interest Expense ..................................... 577,386
2008
June 30 Interest Expense .......................................... 540,000
Cash ......................................................... 540,000
Dec. 31 Interest Expense .......................................... 540,000
Cash ......................................................... 540,000
31 Interest Expense .......................................... 74,772
Discount on Bonds Payable .................. 74,772
31 Income Summary ......................................... 1,154,772
Interest Expense ..................................... 1,154,772
2009
June 30 Bonds Payable ............................................. 12,000,000
Loss on Redemption of Bonds ................... 358,183
Discount on Bonds Payable .................. 598,183
Cash ......................................................... 11,760,000

2. a. 2007: $577,386
b. 2008: $1,154,772

3. Initial carrying amount of bonds .................................. $ 11,252,273

Discount amortized on December 31, 2007................. 37,386
Discount amortized on December 31, 2008................. 74,772
Carrying amount of bonds, December 31, 2008.......... $ 11,364,431

843
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resold, copied, or distributed without the prior consent of the publisher.
Prob. 155B

2007
Sept. 1 Investment in Ivan Company Bonds ................. 853,100
Interest Revenue ($800,000 9% 2/12) .......... 12,000
Cash ................................................................. 865,100
Dec. 31 Cash ($800,000 9% 6/12)............................... 36,000
Interest Revenue ............................................. 36,000
31 Interest Revenue ................................................. 1,800
Investment in Ivan Company Bonds ............. 1,800
2013
June 30 Cash ..................................................................... 36,000
Interest Revenue ............................................. 36,000
Aug. 31 Interest Revenue ................................................. 1,800
Investment in Ivan Company Bonds ............. 1,800
31 Cash ..................................................................... 413,500*
Gain on Sale of Investments.......................... 1,900
Investment in Ivan Company Bonds ............. 405,600
Interest Revenue ............................................. 6,000
*($400,000 1.02) + ($400,000 9% 2/12) $500.
Dec. 31 Cash ..................................................................... 18,000
Interest Revenue ............................................. 18,000
31 Interest Revenue ................................................. 2,700
Investment in Ivan Company Bonds ............. 2,700

844
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Appendix Prob. 156B

1. a. Interest Expense ...................................................... 918,785

Premium on Bonds Payable
[$1,040,000 (5% $18,375,706)] ........................... 121,215
Cash ..................................................................... 1,040,000
b. Interest Expense ...................................................... 912,725
Premium on Bonds Payable
[$1,040,000 (5% $18,254,491)] ........................... 127,275
Cash ..................................................................... 1,040,000

2. $918,785

Appendix Prob. 157B

1. a. Interest Expense ...................................................... 1,220,692

Discount on Bonds Payable
[($20,344,863 6%) $1,210,000] ...................... 10,692
Cash ..................................................................... 1,210,000
b. Interest Expense ...................................................... 1,221,333
Discount on Bonds Payable
[($20,355,555 6%) $1,210,000] ...................... 11,333
Cash ..................................................................... 1,210,000

2. $1,220,692

845
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 COMPREHENSIVE PROBLEM 4

1. a. Cash .......................................................................... 812,500

Common Stock ................................................... 375,000
Paid-In Capital in Excess of Par
Common Stock ................................................... 437,500
b. Cash .......................................................................... 1,600,000
Preferred Stock ................................................... 1,250,000
Paid-In Capital in Excess of Par
Preferred Stock ................................................... 350,000
c. Cash .......................................................................... 16,869,339
Bonds Payable .................................................... 15,000,000
Premium on Bonds Payable .............................. 1,869,339
Computations:
Present value of face amount of $15,000,000 com-
pounded semiannually 0.37689 [present value of
$1 for 20 (semiannual) periods at 5%
(semiannual rate)] .................................................... $ 5,653,350
Present value of semiannual interest payments of
$900,000 at 5% compounded semiannually:
$900,000 12.46221 (present value of annuity
of $1 for 20 periods at 5%) ................................. 11,215,989
Total present value of bonds .................................. $ 16,869,339
d. Cash Dividends ($0.25 125,000) + (2.5 18,750). 78,125
Cash Dividends Payable .................................... 78,125
e. Cash Dividends Payable.......................................... 78,125
Cash ..................................................................... 78,125
f. Bonds Payable ......................................................... 500,000
Premium on Bonds Payable.................................... 6,150
Cash ..................................................................... 505,000
Gain on Redemption of Bonds .......................... 1,150
g. Treasury Stock ......................................................... 390,625
Cash ..................................................................... 390,625

846
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Comp. Prob. 4 Continued

h. Stock Dividends ....................................................... 151,406*

Cash Dividends ........................................................ 46,875
Stock Dividends Distributable ........................... 71,250
Paid-In Capital in Excess of Par
Common Stock ................................................... 80,156
Cash Dividends Payable .................................... 46,875
*125,000 6,250 = 118,750
118,750 2% = 2,375
2,375 $63.75 = $151,406
i. Stock Dividends Distributable ................................ 71,250
Cash Dividends Payable.......................................... 46,875
Common Stock ................................................... 71,250
Cash ..................................................................... 46,875
j. Investment in Lewis Sports Inc. Bonds ................. 145,500
Interest Revenue ...................................................... 5,625
Cash ..................................................................... 151,125
k. Cash .......................................................................... 271,875
Treasury Stock .................................................... 234,375
Paid-In Capital from Sale of Treasury Stock .... 37,500
l. Interest Expense ...................................................... 806,533
Premium on Bonds Payable.................................... 93,467
Cash ..................................................................... 900,000
Computations:
Semiannual interest payment ................................. $900,000
Amortization premium [($1,869,339/120 months)
6 months, rounded] ........................................ 93,467
Interest expense....................................................... $806,533
m. Interest Receivable .................................................. 7,500
Interest Revenue ................................................. 7,500
Interest accrued for four months.
Computation: $150,000 15% 4/12 = $7,500
Investment in Lewis Sports Inc. Bonds ................. 120
Interest Revenue ................................................. 120
Amortization of discounts for four months.

847
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Comp. Prob. 4 Continued
2. a.
DELHOME PRODUCTS INC.
Income Statement
For the Year Ended July 31, 2008
Sales................................................................. $ 6,300,000
Cost of merchandise sold .............................. 3,498,750
Gross profit...................................................... $ 2,801,250
Operating expenses:
Selling expenses:
Sales salaries expense ........................ $360,000
Sales commissions .............................. 195,000
Advertising expense ............................ 150,000
Depreciation expensestore buildings
and equipment................................. 90,000
Delivery expense .................................. 27,000
Store supplies expense ....................... 20,000
Miscellaneous selling expense ........... 13,750 $855,750
Administrative expenses:
Office salaries expense........................ $170,000
Office rent expense .............................. 50,000
Depreciation expenseoffice buildings
and equipment................................. 25,000
Office supplies expense ...................... 10,000
Miscellaneous administrative expense 7,500 262,500
Special charges:
Restructuring charges ......................... $ 93,750
Fixed asset impairment........................ 187,500 281,250
Total expenses ........................................... 1,399,500
Income from operations ................................. $ 1,401,750
Other expenses and income:
Interest revenue ......................................... $ 2,025
Gain on redemption of bonds (net of
applicable income tax of $150)............ 1,000
Interest expense......................................... (778,266) (775,241)
Income from continuing operations before
income tax .................................................. $ 626,509
Income tax ....................................................... 247,509
Income from continuing operations .............. $ 379,000
Loss from disposal of discontinued
operations .................................................. $250,000
Less applicable income tax............................ 100,000 150,000
Net income....................................................... $ 229,000

848
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Comp. Prob. 4 Continued

Earnings per common share:

Income from continuing operations .................................. $1.53*
Loss on discontinued operations ...................................... 1.20
Net income........................................................................... $0.33
*($379,000 $187,500 preferred dividends)/125,000 common shares.

b.
DELHOME PRODUCTS INC.
Retained Earnings Statement
For the Year Ended July 31, 2008
Retained earnings, August 1, 2007 ................ $2,302,970
Net income for year......................................... $229,000
Less dividends:
Cash dividends .......................................... $310,315
Stock dividends ......................................... 151,406 461,721
Decrease in retained earnings ....................... 232,721
Retained earnings, July 31, 2008 ................... $2,070,249

849
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Comp. Prob. 4 Continued

c.
DELHOME PRODUCTS INC.
Balance Sheet
July 31, 2008
Assets
Current assets:
Cash ......................................................... $ 250,000
Accounts receivable ............................... $ 562,500
Less allowance for doubtful accounts.. 43,750 518,750
Notes receivable ..................................... 156,250
Merchandise inventory, at lower of cost
(fifo) or market...................................... 850,000
Interest receivable .................................. 7,500
Prepaid expenses ................................... 31,250
Total current assets ............................. $ 1,813,750
Investments:
Investment in Lewis Sports Inc. bonds 145,620
Property, plant, and equipment:
Store buildings and equipment ............. $ 21,920,876
Less accumulated depreciation............. 4,428,750 $17,492,126
Office buildings and equipment ............ $ 7,412,500
Less accumulated depreciation............. 1,670,650 5,741,850
Total property, plant, and equipment . 23,233,976
Intangible assets:
Goodwill................................................... 540,000
Total assets .................................................. $25,733,346

850
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Comp. Prob. 4 Concluded

Liabilities
Current liabilities:
Accounts payable ...................................... $ 212,000
Employee termination obligation ............. 81,250
Income tax payable.................................... 40,000
Dividends payable ..................................... 37,500
Deferred income tax payable .................... 17,500
Total current liabilities ......................... $ 388,250
Long-term liabilities:
Bonds payable, 11%, due 2018 ................. $14,500,000
Add premium on bonds payable .............. 1,769,722 16,269,722
Deferred credits:
Deferred income tax payable .................... 33,875
Total liabilities ................................................. $ 16,691,847

Stockholders Equity
Paid-in capital:
Preferred 8% stock, $125 par (30,000
shares authorized; 18,750 shares
issued) ................................................... $ 2,343,750
Excess of issue price over par ................. 300,000 $ 2,643,750
Common stock, $30 par (400,000 shares
authorized; 124,875 shares issued) .... $ 3,746,250
Excess of issue price over par ................. 700,000 4,446,250
From sale of treasury stock ...................... 37,500
Total paid-in capital.............................. $ 7,127,500
Retained earnings ........................................... 2,070,249
Total ............................................................ $ 9,197,749
Deduct treasury common stock (2,500
shares at cost)............................................ 156,250
Total stockholders equity.............................. 9,041,499
Total liabilities and stockholders equity ...... $ 25,733,346

851
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 SPECIAL ACTIVITIES

SA 151

GE Capitals action was legal, but caused a great public relations stir at the time.
Some quotes:
A lot of people feel like they have been sorely used, said one bond fund man-
ager. There was nothing illegal about it, but it was nasty.
The fund manager said that GE Capitals decision to upsize its bond issue to $11
billion from $6 billion midway through the offering ordinarily wouldnt have upset
bondholders.
But then to find out two days later that they had filed a $50 billion shelf? he
said. People buy GE because its like buying Treasurys, not because they want
to get jerked around.
GE Capitals action was probably ethical, even though it caused some stir. In its
own defense, it stated:
In a statement released late Thursday, GE Capital said with the $11 billion bond
issuance of March 13, GE Capital exhausted its existing debt shelf registration;
consequently, on March 20, GE Capital filed a $50 billion shelf registration.
The release said the shelf filing was not an offering and that it would be used in
part to roll over $31 billion in maturing long-term debt.
In retrospect, GE Capital could have been a little more forthcoming about its fi-
nancing plans prior to selling the $11 billion on bonds, but there was nothing un-
ethical or illegal about its disclosures.
Source: GE Capital Timing on $50B Shelf Filing Added To Backlash, Dow Jones Capital Markets
Report, March 22, 2002, Copyright (c) 2002, Dow Jones & Company, Inc.

SA 152

Without the consent of the bondholders, Bobs use of the sinking fund cash to
temporarily alleviate the shortage of funds would violate the bond indenture con-
tract and the trust of the bondholders. It would therefore be unprofessional. In
addition, the use of Bobs brother-in-law as trustee of the sinking fund is a poten-
tial conflict of interest that could be considered unprofessional.

852
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SA 153

Receive $5,000,000 today:

Present value of $5,000,000 today = $5,000,000

Receive $2,000,000 today, plus $600,000 per year for 10 years:

Present value of $2,000,000 today = $2,000,000

Present value of annual payments = $600,000 6.41766 (Present value of an
annuity of $1 for 10 periods at 9%) = $3,850,596

Total value = Present value of $2,000,000 + Present value of annual payments

Total value = $2,000,000 + $3,850,596 = $5,850,596

Receive $1,000,000 per year for 10 years:

Present value of annual payments = $1,000,000 6.41766 (Present value of an

annuity of $1 for 10 periods at 9%) = $6,417,660

The option that has the highest value in terms of present value is to receive
$1,000,000 per year for 10 years.

SA 154

The primary advantage of issuing preferred stock rather than bonds is that the
preferred stock does not obligate Beacon to pay dividends, while interest on
bonds must be paid. That is, the issuance of bonds will require annual interest
payments, thus necessitating a periodic (probably semiannual) cash outflow.
Given St. Seniors volatility of operating cash flows, the required interest pay-
ments might strain Beacons liquidity. In the extreme, this could even lead to a
bankruptcy of Beacon.
The issuance of bonds has the advantage of providing a tax deduction for inter-
est expense. This would tend to reduce the net (after-tax) cost of the bonds.
Probably the safest alternative is for Beacon to issue preferred stock. Of course,
another alternative might be to issue a combination of preferred stock and bonds.

853
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SA 155

1. The following table lists the face value, coupon rate, and maturity of each
bond issue.

Face Value Coupon Rate Maturity Date

$243 million 9.875% November 1, 2021
$250 million 9.625% March 15, 2022
$250 million 9.500% May 15, 2022
$240 million 9.125% July 1, 2022
$250 million 8.250% March 1, 2023
$250 million 8.125% June 15, 2023

2. Georgia-Pacific may have called these bond issues early for a number of rea-
sons. These reasons might include refinancing at lower interest rates, using
cash flows from operations to reduce leverage, refinancing debt with equity
through an initial public offering (IPO) or a secondary offering, using the
funds from the sale of a subsidiary to reduce leverage (as was the case with
Georgia-Pacific in this example), or refinancing fixed rate debt with variable
rate debt in anticipation of falling interest rates.

SA 156

Note to Instructors: The purpose of this activity is to familiarize students with

bonds as an investment and the sources of information about bonds.

854
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SA 157

1. Plan 1 Plan 2
Shares of common stock .............................................. 160,000 247,500
Earnings before bond interest and income tax........... $700,000 $700,000
Deduct interest on bonds ............................................. 350,000 227,500
Income before income tax ............................................ $350,000 $472,500
Deduct income tax......................................................... 140,000 189,000
Net income ..................................................................... $210,000 $283,500

Earnings per share on common stock......................... $ 1.31* $ 1.15**

*210,000/160,000
**283,500/(160,000 + 87,500)

2. a. Factors to be considered in addition to earnings per share:

1. There is a definite legal obligation to pay interest on bonds, but there
is no definite commitment to pay dividends on common stock.
Therefore, if net income should drop substantially, bonds would be
less desirable than common stock.
2. If the bonds are issued, there is a definite commitment to repay the
principal in 20 years. In case of liquidation, the claims of the bond-
holders would rank ahead of the claims of the common stockholders.
3. Present stockholders must purchase the new stock if they are to re-
tain their proportionate control and financial interest in the corpora-
tion.
b. Since the net income has been relatively stable in the past and antici-
pated earnings under Plan 1 offer earnings per share of $1.31 for the
common stockholder, Plan 1 appears to be somewhat more advanta-
geous for present stockholders.

SA 158

Note to Instructors: The purpose of this activity is to familiarize students with

bond ratings and the importance of bond ratings to the issuer as well as to the
investor.

855
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SA 159

1. 2003: $22
2004: $1,703
2005: $1,975

2. 2003: 11,620.9 = ($255,638 + $22)/$22

2004: 183.2 = ($310,205 + $1,703)/$1,703
2005: 177.6 = ($348,798 + $1,975)/$1,975

While the companys ratio decreased significantly between 2003 and 2004,
this was due to the fact that the company had virtually no interest expense
before 2004. The companys current ratio of 177.6 times is still extremely
favorable.

856
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