CHAPTER 14
LONG TERM LIABILITIES: BONDS AND NOTES
EYE OPENERS
1. (1) To pay the face (maturity) amount of the
bonds at a specified date. (2) To pay period-
ic 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 general
credit of the corporation.
3. Less than face amount. Because compara-
ble investments in bonds provide a market
interest rate (11%) that is greater than the
rate on the bond being purchased (10%), the
bond will sell at a discount as the market’s
means of equalizing the two interest rates.
4. a. Greater than $9,000,000
b. 1. $9,000,000
2. 7%
3. 9%
4. $9,000,000
5. Less than the contract rate
6. a. Premium
b. $12,085,373
c. Premium on Bonds Payable
7. a. Debit Interest Expense
Credit Discount on Bonds Payable
b. Debit Premium on Bonds Payable
Credit Interest Expense
8. No. A bond discount occurs when the con-
tract rate of interest on a bond is lower than
the market rate of interest. As a result, buy-
ers are not willing to pay full face amount for
the bonds. The discount may be viewed as
the amount needed to entice investors to
accept a contract rate of interest that is be-
low the market rate. The discount is initially
recorded on the balance sheet as a deduc-
tion from bonds payable.
743
9. 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 issue.
10. A loss of $30,000 [($1,000,000  0.98) –
($1,000,000 – $50,000)]
11. A mortgage note is an installment note that
is secured by a pledge of the borrower’s as-
sets. In other words, if the borrower fails to
pay the note, the lender has the right to take
possession of the pledged asset and sell it to
pay off the debt.
12. A bond is an interest-bearing note that
requires periodic interest payments and
repayment of the face amount of the bonds
at maturity. Thus, bonds consist of two dif-
ferent components: (1) interest payments
made periodically over the life of the bond
and (2) the face amount that must be repaid
at maturity. Therefore, the periodic payments
consist entirely of interest, and the final
payment at maturity consists entirely of prin-
cipal. Installment notes, on the other hand,
have periodic payments that consist partially
of interest, and partially of principal. Each
payment reduces the principal on the note
so that at maturity the entire amount bor-
rowed will have been repaid.
13. a. As a current liability
b. As a long-term liability
14. As an addition to the related bonds payable
15. 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.
16. (b) $10,000 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.
 PRACTICE EXERCISES

PE 14–1A

Plan 1 Plan 2
Earnings before bond interest and income tax ............... $800,000 $800,000
Bond interest ...................................................................... 200,0001 100,0003
Balance ............................................................................... $600,000 $700,000
Income tax .......................................................................... 240,0002 280,0004
Net income .......................................................................... $360,000 $420,000
Dividends on preferred stock ............................................ 0 300,000
Earnings available for common stock .............................. $360,000 $120,000
Number of common shares ............................................... ÷400,000 ÷300,000
Earnings per share on common stock ............................. $ 0.90 $ 0.40
1$2,000,000 × 10%
2$600,000 × 40%
3$1,000,000 × 10%
4$700,000 × 40%

PE 14–1B

Plan 1 Plan 2
Earnings before bond interest and income tax ............... $1,000,000 $1,000,000
Bond interest ...................................................................... 400,0001 320,0003
Balance .............................................................................. $ 600,000 $ 680,000
Income tax .......................................................................... 240,0002 272,0004
Net income .......................................................................... $ 360,000 $ 408,000
Dividends on preferred stock ............................................ 0 200,000
Earnings available for common stock .............................. $ 360,000 $ 208,000
Number of common shares ............................................... ÷ 200,000 ÷ 160,000
Earnings per share on common stock ............................. $ 1.80 $ 1.30
1$5,000,000 × 8%
2$600,000 × 40%
3$4,000,000 × 8%
4$680,000 × 40%

744
PE 14–2A

Cash ...................................................................................... 942,646

Discount on Bonds Payable ................................................ 57,354
Bonds Payable ................................................................ 1,000,000

PE 14–2B

Cash ...................................................................................... 663,128

Discount on Bonds Payable ................................................ 86,872
Bonds Payable ................................................................ 750,000

PE 14–3A

Interest Expense .................................................................. 57,868

Discount on Bonds Payable........................................... 2,868
Cash ................................................................................. 55,000
Paid interest and amortized the bond discount
($57,354 ÷ 20).

PE 14–3B

Interest Expense .................................................................. 34,937

Discount on Bonds Payable........................................... 8,687
Cash ................................................................................. 26,250
Paid interest and amortized the bond discount
($86,872 ÷ 10).

PE 14–4A

Cash ...................................................................................... 5,193,030

Premium on Bonds Payable .......................................... 193,030
Bonds Payable ................................................................ 5,000,000

PE 14–4B

Cash ...................................................................................... 3,146,200

Premium on Bonds Payable .......................................... 146,200
Bonds Payable ................................................................ 3,000,000

745
PE 14–5A

Interest Expense .................................................................. 255,697

Premium on Bonds Payable ................................................ 19,303
Cash ................................................................................. 275,000
Paid interest and amortized the bond premium
($193,030 ÷ 10).

PE 14–5B

Interest Expense ..................................................................... 165,380

Premium on Bonds Payable ................................................... 14,620
Cash .................................................................................... 180,000
Paid interest and amortized the bond premium
($146,200 ÷ 10).

PE 14–6A

Bonds Payable......................................................................... 500,000

Loss on Redemption of Bonds .............................................. 25,000
Discount on Bonds Payable.............................................. 50,000
Cash .................................................................................... 475,000

PE 14–6B

Bonds Payable......................................................................... 200,000

Premium on Bonds Payable ................................................... 15,000
Gain on Redemption of Bonds ......................................... 20,000
Cash .................................................................................... 195,000

746
PE 14–7A

a. Cash................................................................................... 65,000
Notes Payable ............................................................... 65,000
Issued $65,000 of installment notes for cash.

b. Interest Expense ............................................................... 6,500

Notes Payable ................................................................... 8,424
Cash ............................................................................... 14,924
Paid principal and interest on installment notes.

PE 14–7B

a. Cash................................................................................... 35,000
Notes Payable ............................................................... 35,000
Issued $35,000 of installment notes for cash.

b. Interest Expense ............................................................... 4,200

Notes Payable ................................................................... 5,509
Cash ............................................................................... 9,709
Paid principal and interest on installment notes.

747
 EXERCISES

Ex. 14–1

Miller
Co.
a. Earnings before bond interest and income tax .......... $ 3,000,000
Bond interest ................................................................. 1,000,000
Balance ........................................................................... $ 2,000,000
Income tax ...................................................................... 800,000
Net income ..................................................................... $ 1,200,000
Dividends on preferred stock ....................................... 1,000,000
Earnings available for common stock ......................... $ 200,000
Earnings per share on common stock ........................ $ 0.50
b. Earnings before bond interest and income tax .......... $ 4,000,000
Bond interest ................................................................. 1,000,000
Balance ........................................................................... $ 3,000,000
Income tax ...................................................................... 1,200,000
Net income ..................................................................... $ 1,800,000
Dividends on preferred stock ....................................... 1,000,000
Earnings available for common stock ......................... $ 800,000
Earnings per share on common stock ........................ $ 2.00
c. Earnings before bond interest and income tax .......... $ 5,000,000
Bond interest ................................................................. 1,000,000
Balance ........................................................................... $ 4,000,000
Income tax ...................................................................... 1,600,000
Net income ..................................................................... $ 2,400,000
Dividends on preferred stock ....................................... 1,000,000
Earnings available for common stock ......................... $ 1,400,000
Earnings per share on common stock ........................ $ 3.50

Ex. 14–2

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.

748
Ex. 14–3

Nike’s major source of funding is common stock. It has long-term debt, excluding
current installments, of $409.5 million, compared to stockholders’ equity of
$7,025.4 million.

Ex. 14–4

The bonds were selling at a premium. This is indicated by the selling price of
126.987, 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
8%, and this is why the bonds were selling at a premium.

Ex. 14–5

Apr. 1 Cash ..................................................................... 24,000,000

Bonds Payable ................................................ 24,000,000
Oct. 1 Interest Expense ................................................. 1,200,000
Cash ................................................................. 1,200,000
Dec. 31 Interest Expense ................................................. 600,000*
Interest Payable .............................................. 600,000
Accrue interest.
*24,000,000 × 10% × 3/12

Ex. 14–6

a. 1. Cash .......................................................................... 44,346,760

Discount on Bonds Payable .................................... 5,653,240
Bonds Payable .................................................... 50,000,000
2. Interest Expense ...................................................... 2,000,000
Cash ..................................................................... 2,000,000
3. Interest Expense ...................................................... 2,000,000
Cash ..................................................................... 2,000,000
4. Interest Expense ...................................................... 1,130,648
Discount on Bonds Payable .............................. 1,130,648
$5,653,240 ÷ 5 years = $1,130,648.
b. Annual interest paid ...................................................... $4,000,000
Plus discount amortized ............................................... 1,130,648
Interest expense for first year ...................................... $5,130,648

749
Ex. 14–7

a. Cash ................................................................................ 25,853,146

Premium on Bonds Payable .................................... 1,853,146
Bonds Payable ......................................................... 24,000,000
b. Interest Expense ............................................................ 1,254,685
Premium on Bonds Payable ......................................... 185,315*
Cash .......................................................................... 1,440,000**
*$1,853,146 ÷ 10 semiannual payments
**$24,000,000 × 12% × 6/12

Ex. 14–8

2010
Apr. 1 Cash ..................................................................... 16,000,000
Bonds Payable ................................................ 16,000,000
Oct. 1 Interest Expense ................................................. 880,000
Cash ................................................................. 880,000
2014
Oct. 1 Bonds Payable .................................................... 16,000,000
Loss on Redemption of Bonds .......................... 320,000
Cash ................................................................. 16,320,000*
*$16,000,000 × 1.02

Ex. 14–9

2010
Jan. 1 Cash ..................................................................... 15,000,000
Bonds Payable ................................................ 15,000,000
July 1 Interest Expense ................................................. 1,050,000
Cash ................................................................. 1,050,000
2016
July 1 Bonds Payable .................................................... 15,000,000
Gain on Redemption of Bonds ...................... 300,000
Cash ................................................................. 14,700,000*
*$15,000,000 × 0.98

750
Ex. 14–10

a. 1. Cash .......................................................................... 44,000

Notes Payable ..................................................... 44,000
Issued $44,000 of installment notes for cash.
2. Interest Expense ...................................................... 2,200
Notes Payable ........................................................... 5,404
Cash ..................................................................... 7,604
Paid principal and interest on installment notes.
b. Interest expense, $2,200

Ex. 14–11

2010
Jan. 1 Cash ..................................................................... 140,000
Notes Payable ................................................. 140,000
Issued $140,000 of installment notes for cash.
Dec. 31 Interest Expense ................................................. 15,400
Notes Payable ..................................................... 8,372
Cash ................................................................. 23,772
Paid principal and interest on installment notes.
2019
Dec. 31 Interest Expense ................................................. 2,353
Notes Payable ..................................................... 21,419
Cash ................................................................. 23,772
Paid principal and interest on installment notes.

Ex. 14–12

a.
Amortization of Installment Notes
A B C D E
December
Decrease 31
January 1 Note in Notes Carrying
Carrying Payment Interest Expense (6.5% of January 1 Payable Amount
For the Year Ending: Amount (Cash Paid) Note Carrying Amount) (B – C) (A – D)
December 31, 2010 $52,000 $15,179 $3,380 (6.5% of $52,000) $11,799 $40,201
December 31, 2011 40,201 15,179 2,613 (6.5% of $40,201) 12,566 27,635
December 31, 2012 27,635 15,179 1,796 (6.5% of $27,635) 13,383 14,252
December 31, 2013 14,252 15,179 927 (6.5% of $14,252) 14,252 0
$60,716 $8,716 $52,000

751
Ex. 14–12 Concluded

b.
2010
Jan. 1 Cash ..................................................................... 52,000
Notes Payable ................................................. 52,000
Issued $52,000 of installment notes for cash.
Dec. 31 Interest Expense ................................................. 3,380
Notes Payable ..................................................... 11,799
Cash ................................................................. 15,179
Paid principal and interest on installment notes.
2011
Dec. 31 Interest Expense ................................................. 2,613
Notes Payable ..................................................... 12,566
Cash ................................................................. 15,179
Paid principal and interest on installment notes.
2012
Dec. 31 Interest Expense ................................................. 1,796
Notes Payable ..................................................... 13,383
Cash ................................................................. 15,179
Paid principal and interest on installment notes.
2013
Dec. 31 Interest Expense ................................................. 927
Notes Payable ..................................................... 14,252
Cash ................................................................. 15,179
Paid principal and interest on installment notes.

Ex. 14–13

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 current liability on the balance sheet because they mature within
one year.

752
Appendix 1 Ex. 14–14

a. $400,000 ÷ 1.10 = $363,636

$363,636 ÷ 1.10 = $330,578
$330,578 ÷ 1.10 = $300,525

b. $400,000 × 0.75132 = $300,528*

*There is a slight difference between parts (a) and (b) due to rounding.

Appendix 1 Ex. 14–15

a. First Year: $100,000 × 0.94340 = $ 94,340

Second Year: $100,000 × 0.89000 = 89,000
Third Year: $100,000 × 0.83962 = 83,962
Fourth Year: $100,000 × 0.79209 = 79,209
Total present value $346,511

b. $100,000 × 3.46511 = $346,511

Appendix 1 Ex. 14–16

$3,000,000 × 7.02358 = $21,070,740

Appendix 1 Ex. 14–17

No. The present value of your winnings using an interest rate of 14% is
$15,648,360 ($3,000,000 × 5.21612), which is more than one-half of the present
value of your winnings using an interest rate of 7% ($21,070,740; see Appendix 1
Ex. 14–16). This is because of the effect of compounding the interest. That is,
compound interest functions are not linear functions, but use exponents.

753
Appendix 1 Ex. 14–18

Present value of $1 for 10 (semiannual)

periods at 6% (semiannual rate) .......................... 0.55840
Face amount of bonds ............................................... × $10,000,000 $5,584,000
Present value of an annuity of $1
for 10 periods at 6% .............................................. 7.36009
Semiannual interest payment ................................... × $500,000 3,680,045
Total present value (proceeds) ................................. $9,264,045

Appendix 1 Ex. 14–19

Present value of $1 for 10 (semiannual)

periods at 5% (semiannual rate) .......................... 0.61391
Face amount of bonds ............................................... × $60,000,000 $36,834,600
Present value of an annuity of $1
for 10 periods at 5% .............................................. 7.72174
Semiannual interest payment ................................... × $4,200,000 32,431,308
Total present value (proceeds) ................................. $69,265,908

754
Appendix 2 Ex. 14–20

a. 1. Cash .......................................................................... 20,868,138

Discount on Bonds Payable .................................... 4,131,862
Bonds Payable .................................................... 25,000,000
2. Interest Expense ...................................................... 1,356,429*
Discount on Bonds Payable .............................. 106,429
Cash ..................................................................... 1,250,000
*$20,868,138 × 6.5%
3. Interest Expense ...................................................... 1,363,347*
Discount on Bonds Payable .............................. 113,347
Cash ..................................................................... 1,250,000
*($20,868,138 + $106,429) × 6.5%
Note: The following data in support of the proceeds of the bond issue stated
in the exercise are presented for the instructor’s information. Students are
not required to make the computations.
Present value of $1 for 10 (semiannual)
periods at 6.5% (semiannual rate) .................. 0.28380
Face amount .......................................................... × $25,000,000 $ 7,095,000
Present value of annuity of $1 for
10 periods at 6.5% ............................................ 11.01851
Semiannual interest payment ............................... × $1,250,000 13,773,138
Total present value of bonds payable.................. $20,868,138
b. Annual interest paid .............................................. $ 2,500,000
Plus discount amortized ....................................... 219,776
Interest expense for first year .............................. $ 2,719,776

755
Appendix 2 Ex. 14–21

a. 1. Cash .......................................................................... 8,588,850

Premium on Bonds Payable .............................. 588,850
Bonds Payable .................................................... 8,000,000
2. Interest Expense ...................................................... 515,331*
Premium on Bonds Payable .................................... 44,669
Cash ..................................................................... 560,000
*$8,588,850 × 6%
3. Interest Expense ...................................................... 512,651*
Premium on Bonds Payable .................................... 47,349
Cash ..................................................................... 560,000
*($8,588,850 – $44,669) × 6%
b. Annual interest paid ...................................................... $1,120,000
Less premium amortized .............................................. 92,018
Interest expense for first year ...................................... $1,027,982

Appendix 2 Ex. 14–22

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

periods at 6.5% (semiannual rate) .......................... 0.53273
Face amount ............................................................. × $15,000,000 $ 7,990,950
Present value of annuity of $1 for 10
periods at 6.5% ......................................................... 7.18883
Semiannual interest payment .................................. × $1,125,000 8,087,434
Proceeds of bond sale ............................................. $16,078,384
b. First semiannual interest payment ......................... $ 1,125,000
6.5% of carrying amount of $16,078,384 ................. 1,045,095
Premium amortized .................................................. $ 79,905
c. Second semiannual interest payment .................... $ 1,125,000
6.5% of carrying amount of $15,998,479* ............... 1,039,901
Premium amortized .................................................. $ 85,099
*$16,078,384 – $79,905 = $15,998,479
d. Annual interest paid ................................................. $ 2,250,000
Less premium amortized ......................................... 165,004*
Interest expense for first year ................................. $ 2,084,996
*$79,905 + $85,099 = $165,004

756
Appendix 2 Ex. 14–23

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

periods at 7% (semiannual rate) ............................. 0.50835
Face amount ............................................................. × $40,000,000 $20,334,000
Present value of annuity of $1 for 10 periods at 7% ... 7.02358
Semiannual interest payment .................................. × $2,200,000 15,451,876
Proceeds of bond sale ............................................. $35,785,876
b. 7% of carrying amount of $35,785,876 .................... $ 2,505,011
First semiannual interest payment ......................... 2,200,000
Discount amortized .................................................. $ 305,011
c. 7% of carrying amount of $36,090,887* .................. $ 2,526,362
Second semiannual interest payment .................... 2,200,000
Discount amortized .................................................. $ 326,362
*$35,785,876 + $305,011 = $36,090,887
d. Annual interest paid ................................................. $ 4,400,000
Plus discount amortized .......................................... 631,373*
Interest expense first year ....................................... $ 5,031,373
*$305,011 + $326,362 = $631,373

757
Ex. 14–24

a. Current year:
$325,000,000  $56,000,000
Number of times interest charges earned: 6.8 =
$56,000,000

Preceding year:
$450,000,000  $60,000,000
Number of times interest charges earned: 8.5 =
$60,000,000

b. The number of times interest charges earned has declined from 8.5 to 6.8 in
the current year. Although Southwest Airlines has adequate earnings to pay
interest, the decline in this ratio may cause concern among debtholders.

758
 PROBLEMS

Prob. 14–1A

1. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $2,000,000 $2,000,000 $2,000,000
Deduct interest on bonds ............................... 0 0 500,000
Income before income tax .............................. $2,000,000 $2,000,000 $1,500,000
Deduct income tax .......................................... 800,000 800,000 600,000
Net income ....................................................... $1,200,000 $1,200,000 $ 900,000
Dividends on preferred stock ......................... 0 500,000 250,000
Available for dividends on common stock.... $1,200,000 $ 700,000 $ 650,000
Shares of common stock outstanding .......... ÷1,000,000 ÷ 500,000 ÷ 250,000
Earnings per share on common stock .......... $ 1.20 $ 1.40 $ 2.60

2. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $ 950,000 $950,000 $950,000
Deduct interest on bonds ............................... 0 0 500,000
Income before income tax .............................. $ 950,000 $950,000 $450,000
Deduct income tax .......................................... 380,000 380,000 180,000
Net income ....................................................... $ 570,000 $570,000 $270,000
Dividends on preferred stock ......................... 0 500,000 250,000
Available for dividends on common stock.... $ 570,000 $ 70,000 $ 20,000
Shares of common stock outstanding .......... ÷ 1,000,000 ÷500,000 ÷250,000
Earnings per share on common stock .......... $ 0.57 $ 0.14 $ 0.08

759
Prob. 14–1A Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of

common 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
interest and income tax is $950,000. In this case, it has the largest EPS
($0.57). 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 $2,000,000,
this plan offers the lowest EPS ($1.20) 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 ($2.60) if earnings before
interest and income tax is $2,000,000. 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 ($0.08)
if earnings before interest and income tax is $950,000.

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

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

760
Prob. 14–2A

1. Cash ........................................................................... 30,237,139

Discount on Bonds Payable .................................... 1,762,861
Bonds Payable .................................................... 32,000,000

2. a. Interest Expense ................................................. 2,008,143

Discount on Bonds Payable
($1,762,861 ÷ 20) ............................................ 88,143
Cash ................................................................ 1,920,000
b. Interest Expense ................................................. 2,008,143
Discount on Bonds Payable ......................... 88,143
Cash ................................................................ 1,920,000

3. $2,008,143

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.

5. Present value of $1 for 20 (semiannual)

periods at 6.5% (semiannual rate) .......................... 0.28380
Face amount ............................................................. × $32,000,000 $ 9,081,600
Present value of annuity of $1 for 20 periods at 6.5%. 11.01851
Semiannual interest payment .................................. × $1,920,000 21,155,539
Proceeds of bond issue ........................................... $30,237,139

761
Prob. 14–3A

1. Cash ........................................................................... 3,461,181

Premium on Bonds Payable ............................... 461,181
Bonds Payable .................................................... 3,000,000

2. a. Interest Expense ................................................. 164,627

Premium on Bonds Payable ($461,181 ÷ 30) .... 15,373
Cash ................................................................ 180,000
b. Interest Expense ................................................. 164,627
Premium on Bonds Payable ............................... 15,373
Cash ................................................................ 180,000

3. $164,627

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.

5. Present value of $1 for 30 (semiannual)

periods at 5% (semiannual rate) ............................. 0.23138
Face amount ............................................................. × $3,000,000 $ 694,140
Present value of annuity of $1 for 30 periods at 5% ... 15.37245
Semiannual interest payment .................................. × $180,000 2,767,041
Proceeds of bond issue ........................................... $3,461,181

762
Prob. 14–4A

1.
2010
July 1 Cash .............................................................. 16,675,184
Discount on Bonds Payable ........................ 1,324,816
Bonds Payable ........................................ 18,000,000
Oct. 1 Cash .............................................................. 400,000
Notes Payable ......................................... 400,000
Dec. 31 Interest Expense .......................................... 7,000
Interest Payable ...................................... 7,000
31 Interest Expense .......................................... 900,000
Cash ......................................................... 900,000
31 Interest Expense .......................................... 132,482
Discount on Bonds Payable .................. 132,482
31 Income Summary ......................................... 1,039,482
Interest Expense ..................................... 1,039,482
2011
June 30 Interest Expense .......................................... 900,000
Cash ......................................................... 900,000
Sept. 30 Interest Expense .......................................... 21,000
Interest Payable ............................................ 7,000
Notes Payable ............................................... 28,951
Cash ......................................................... 56,951
Dec. 31 Interest Expense .......................................... 6,493
Interest Payable ...................................... 6,493
31 Interest Expense .......................................... 900,000
Cash ......................................................... 900,000
31 Interest Expense .......................................... 264,964
Discount on Bonds Payable .................. 264,964
31 Income Summary ......................................... 2,092,457
Interest Expense ..................................... 2,092,457
2012
June 30 Bonds Payable ............................................. 18,000,000
Loss on Redemption of Bonds ................... 254,888
Discount on Bonds Payable .................. 794,888
Cash ......................................................... 17,460,000*
*$18,000,000 × 0.97

763
Prob. 14–4A Concluded

2012
Sept. 30 Interest Expense .......................................... 19,480
Interest Payable ............................................ 6,493
Notes Payable ............................................... 30,978
Cash ......................................................... 56,951

2. a. 2010: $1,039,482
b. 2011: $2,092,457

3. Initial carrying amount of bonds .................................. $16,675,184

Discount amortized on December 31, 2010 ................. 132,482
Discount amortized on December 31, 2011 ................. 264,964
Carrying amount of bonds, December 31, 2011 .......... $17,072,630

764
Appendix 2 Prob. 14–5A

1. 2010
July 1 Cash .............................................................. 30,237,139
Discount on Bonds Payable ........................ 1,762,861
Bonds Payable ........................................ 32,000,000

2.
a. 2010
Dec. 31 Interest Expense .......................................... 1,965,414*
Discount on Bonds Payable .................. 45,414
Cash ......................................................... 1,920,000
*$30,237,139 × 6.5%
b. 2011
June 30 Interest Expense .......................................... 1,968,366*
Discount on Bonds Payable .................. 48,366
Cash ......................................................... 1,920,000
*($30,237,139 + $45,414) × 6.5%

3. $1,965,414

Appendix 2 Prob. 14–6A

1. 2010
July 1 Cash .............................................................. 3,461,181
Premium on Bonds Payable .................. 461,181
Bonds Payable ........................................ 3,000,000

2.
a. 2010
Dec. 31 Interest Expense .......................................... 173,059*
Premium on Bonds Payable ........................ 6,941
Cash ......................................................... 180,000
*$3,461,181 × 5%
b. 2011
June 30 Interest Expense .......................................... 172,712*
Premium on Bonds Payable ........................ 7,288
Cash ......................................................... 180,000
*($3,461,181 – $6,941) × 5%

3. $173,059

765
Prob. 14–1B

1. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $15,000,000 $15,000,000 $15,000,000
Deduct interest on bonds ............................... 0 0 4,800,000
Income before income tax .............................. $15,000,000 $15,000,000 $10,200,000
Deduct income tax .......................................... 6,000,000 6,000,000 4,080,000
Net income ....................................................... $ 9,000,000 $ 9,000,000 $ 6,120,000
Dividends on preferred stock ......................... 0 3,000,000 1,000,000
Available for dividends on common stock.... $ 9,000,000 $ 6,000,000 $ 5,120,000
Shares of common stock outstanding .......... ÷ 6,000,000 ÷ 3,000,000 ÷ 1,000,000
Earnings per share on common stock .......... $ 1.50 $ 2.00 $ 5.12

2. Plan 1 Plan 2 Plan 3

Earnings before interest and income tax ...... $ 7,000,000 $ 7,000,000 $ 7,000,000
Deduct interest on bonds ............................... 0 0 4,800,000
Income before income tax .............................. $ 7,000,000 $ 7,000,000 $ 2,200,000
Deduct income tax .......................................... 2,800,000 2,800,000 880,000
Net income ....................................................... $ 4,200,000 $ 4,200,000 $ 1,320,000
Dividends on preferred stock ......................... 0 3,000,000 1,000,000
Available for dividends on common stock.... $ 4,200,000 $ 1,200,000 $ 320,000
Shares of common stock outstanding .......... ÷ 6,000,000 ÷ 3,000,000 ÷ 1,000,000
Earnings per share on common stock .......... $ 0.70 $ 0.40 $ 0.32

766
Prob. 14–1B Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of

common 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
interest and income tax is $7,000,000. In this case, it has the largest EPS
($0.70). 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 $15,000,000,
this plan offers the lowest EPS ($1.50) 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 ($5.12) if earnings
before interest and income tax is $15,000,000. 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
($0.32) if earnings before interest and income tax is $7,000,000.

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

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

767
Prob. 14–2B

1. Cash ........................................................................... 35,465,423

Discount on Bonds Payable .................................... 9,534,577
Bonds Payable .................................................... 45,000,000

2. a. Interest Expense ................................................. 2,726,729

Discount on Bonds Payable
($9,534,577 ÷ 20) ............................................ 476,729
Cash ................................................................ 2,250,000
b. Interest Expense ................................................. 2,726,729
Discount on Bonds Payable ......................... 476,729
Cash ................................................................ 2,250,000

3. $2,726,729

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.

5. Present value of $1 for 20 (semiannual)

periods at 7% (semiannual rate) ............................. 0.25842
Face amount ............................................................. × $45,000,000 $11,628,900
Present value of annuity of $1 for 20 periods at 7% ... 10.59401
Semiannual interest payment .................................. × $2,250,000 23,836,523
Proceeds of bond issue ........................................... $35,465,423

768
Prob. 14–3B

1. Cash ........................................................................... 42,390,112

Premium on Bonds Payable ............................... 2,390,112
Bonds Payable .................................................... 40,000,000

2. a. Interest Expense ................................................. 2,280,494

Premium on Bonds Payable ($2,390,112 ÷ 20) . 119,506
Cash ................................................................ 2,400,000
b. Interest Expense ................................................. 2,280,494
Premium on Bonds Payable ............................... 119,506
Cash ................................................................ 2,400,000

3. $2,280,494

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.

5. Present value of $1 for 20 (semiannual)

periods at 5.5% (semiannual rate) .......................... 0.34273
Face amount ............................................................. × $40,000,000 $13,709,200
Present value of annuity of $1 for 20 periods at 5.5%. 11.95038
Semiannual interest payment .................................. × $2,400,000 28,680,912
Proceeds of bond issue ........................................... $42,390,112

769
Prob. 14–4B

1.
2010
July 1 Cash .............................................................. 12,390,085
Premium on Bonds Payable .................. 2,390,085
Bonds Payable ........................................ 10,000,000
Oct. 1 Cash .............................................................. 225,000
Notes Payable ......................................... 225,000
Dec. 31 Interest Expense .......................................... 4,500
Interest Payable ...................................... 4,500
31 Interest Expense .......................................... 750,000
Cash ......................................................... 750,000
31 Premium on Bonds Payable ........................ 119,504
Interest Expense ..................................... 119,504
31 Income Summary ......................................... 634,966
Interest Expense ..................................... 634,966
2011
June 30 Interest Expense .......................................... 750,000
Cash ......................................................... 750,000
Sept. 30 Interest Expense .......................................... 13,500
Interest Payable ............................................ 4,500
Notes Payable ............................................... 30,671
Cash ......................................................... 48,671
Dec. 31 Interest Expense .......................................... 3,887
Interest Payable ...................................... 3,887
31 Interest Expense .......................................... 750,000
Cash ......................................................... 750,000
31 Premium on Bonds Payable ........................ 239,008
Interest Expense ..................................... 239,008
31 Income Summary ......................................... 1,287,379
Interest Expense ..................................... 1,287,379
2012
June 30 Bonds Payable ............................................. 10,000,000
Premium on Bonds Payable ........................ 1,912,069
Gain on Redemption of Bonds .............. 1,762,069
Cash ($10,000,000 × 101.5%) ................. 10,150,000

770
Prob. 14–4B Concluded

2012
Sept. 30 Interest Expense .......................................... 11,659
Interest Payable ............................................ 3,887
Notes Payable............................................... 33,125
Cash ......................................................... 48,671

2. a. 2010: $634,996
b. 2011: $1,287,379

3. Initial carrying amount of bonds .................................. $12,390,085

Premium amortized on December 31, 2010 ................. (119,504)
Premium amortized on December 31, 2011 ................. (239,008)
Carrying amount of bonds, December 31, 2011.......... $12,031,573

771
Appendix 2 Prob. 14–5B

1. 2010
July 1 Cash .............................................................. 35,465,423
Discount on Bonds Payable ........................ 9,534,577
Bonds Payable ........................................ 45,000,000

2.
a. 2010
Dec. 31 Interest Expense .......................................... 2,482,580*
Discount on Bonds Payable .................. 232,580
Cash ......................................................... 2,250,000
*$35,465,423 × 7%
b. 2011
June 30 Interest Expense .......................................... 2,498,860*
Discount on Bonds Payable .................. 248,860
Cash ......................................................... 2,250,000
*($35,465,423 + $232,580) × 7%

3. $2,482,580

Appendix 2 Prob. 14–6B

1. 2010
July 1 Cash .............................................................. 42,390,112
Premium on Bonds Payable .................. 2,390,112
Bonds Payable ........................................ 40,000,000

2.
a. 2010
Dec. 31 Interest Expense .......................................... 2,331,456*
Premium on Bonds Payable ........................ 68,544
Cash ......................................................... 2,400,000
*$42,390,112 × 5.5%
b. 2011
June 30 Interest Expense .......................................... 2,327,686*
Premium on Bonds Payable ........................ 72,314
Cash ......................................................... 2,400,000
*($42,390,112 – $68,544) × 5.5%

3. $2,331,456

772
 SPECIAL ACTIVITIES

Activity 14–1

GE Capital’s 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 Capital’s decision to upsize its bond issue to $11
billion from $6 billion midway through the offering ordinarily wouldn’t 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 it’s like buying Treasuries, not because they want
to get jerked around.”
GE Capital’s 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.

Activity 14–2

Without the consent of the bondholders, Abdou’s 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 Abdou’s brother-in-law as trustee of the sinking fund is a po-
tential conflict of interest that could be considered unprofessional.

773
Activity 14–3

Receive $10,000,000 today:

Present value of $10,000,000 today = $10,000,000

Receive $2,200,000 today, plus $1,050,000 per year for 15 years:

Present value of $2,200,000 today = $2,200,000

Present value of annual payments = $1,050,000 × 6.81086 (Present value of an
annuity of $1 for 15 periods at 12%) = $7,151,403

Total value = Present value of $2,200,000 + Present value of annual payments

Total value = $2,200,000 + $7,151,403 = $9,351,403

Receive $1,200,000 per year for 15 years:

Present value of annual payments = $1,200,000 × 6.81086 (Present value of an

annuity of $1 for 15 periods at 12%) = $8,173,032

The option that has the highest value in terms of present value is to receive
$10,000,000 today.

Activity 14–4

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 Beacon’s 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.

774
Activity 14–5

1. Plan 1 Plan 2
Shares of common stock .............................................. 200,000 300,000
Earnings before bond interest and income tax .......... $1,000,000 $1,000,000
Deduct interest on bonds ............................................. 600,000 280,000
Income before income tax ............................................ $ 400,000 $ 720,000
Deduct income tax ......................................................... 160,000 288,000
Net income ..................................................................... $ 240,000 $ 432,000
Earnings per share on common stock ........................ $ 1.20* $ 1.44**
*240,000 ÷ 200,000
**432,000 ÷ (200,000 + 100,000)

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 10 years. In case of liquidation, the claims of the bond-
holders would rank ahead of the claims of the common stockhold-
ers.
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 anticipat-
ed earnings under Plan 2 offer earnings per share of $1.44 for the com-
mon stockholder, Plan 2 appears to be somewhat more advantageous
for stockholders.

Activity 14–6

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.

775
Activity 14–7

$800 + $36,485
1. 2007: 46.61 =
$800

$774 + $20,108
2006: 26.98 =
$774

$3,188 + $13,255
2005: 5.16 =
$3,188

2. The company’s times interest earned ratio has increased significantly from
2005 to 2007. This was due to the company’s strong earnings during this pe-
riod, which was used to pay down the company’s debt, reducing its interest
expense and increasing its times interest earned ratio.

776