654 Chapter 14 Long-Term Liabilities: Bonds and Notes

On July 1, 2010, Linux Corporation, a wholesaler of electronics equipment, issued

$45,000,000 of 10-year, 10% bonds at an effective interest rate of 14%, receiving cash of

$35,465,423. Interest on the bonds is payable semiannually on December 31 and June

30. The fiscal year of the company is the calendar year.

Instructions1. Journalize the entry to record the amount of cash proceeds from the sale of the bonds.2. Journalize the entries to record the following:

a. The first semiannual interest payment on December 31, 2010, and the amortizationof the bond discount, using the interest method. (Round to the nearest dollar.)

b. The interest payment on June 30, 2011, and the amortization of the bond discount,using the interest method. (Round to the nearest dollar.)

3. Determine the total interest expense for 2010.

Appendix 2PR 14-5BBond discount, entries for bondspayable transactions,interest method ofamortizing bond discount

✔ 3. $2,482,580

Prosser Corporation produces and sells baseball cards. On July 1, 2010, Prosser

Corporation issued $40,000,000 of 10-year, 12% bonds at an effective interest rate of

11%, receiving cash of $42,390,112. Interest on the bonds is payable semiannually on

December 31 and June 30. The fiscal year of the company is the calendar year.

Instructions1. Journalize the entry to record the amount of cash proceeds from the sale of the bonds.2. Journalize the entries to record the following:

a. The first semiannual interest payment on December 31, 2010, and the amortizationof the bond premium, using the interest method. (Round to the nearest dollar.)

b. The interest payment on June 30, 2011, and the amortization of the bond premium, using the interest method. (Round to the nearest dollar.)

3. Determine the total interest expense for 2010.

Appendix 2PR 14-6BBond premium, entries for bondspayable transactions,interest method ofamortizing bond premium

✔ 3. $2,331,456

Special Activities

General Electric Capital, a division of General Electric, uses long-term debt extensively.In a recent year, GE Capital issued $11 billion in long-term debt to investors, then withindays filed legal documents to prepare for another $50 billion long-term debt issue. Asa result of the $50 billion filing, the price of the initial $11 billion offering declined (dueto higher risk of more debt).

Bill Gross, a manager of a bond investment fund, “denounced a ‘lack in candor’ related toGE’s recent debt deal. ‘It was the most recent and most egregious example of how bond-holders are mistreated.’ Gross argued that GE was not forthright when GE Capital recentlyissued $11 billion in bonds, one of the largest issues ever from a U.S. corporation. Whatbothered Gross is that three days after the issue the company announced its intention tosell as much as $50 billion in additional debt, warrants, preferred stock, guarantees, lettersof credit and promissory notes at some future date.”

In your opinion, did GE Capital act unethically by selling $11 billion of long-

term debt without telling those investors that a few days later it would be filing doc-

uments to prepare for another $50 billion debt offering?

Source: Jennifer Ablan, “Gross Shakes the Bond Market; GE Calms It, a Bit,” Barron’s, March 25, 2002.

SA 14-1General Electric bond issuance

Lachgar Industries develops and produces bio diesel, an alternative energy source. The

company has an outstanding $200,000,000, 30-year, 12% bond issue dated July 1, 2005.

The bond issue is due June 30, 2035. The bond indenture requires a bond sinking fund,

which has a balance of $24,000,000 as of July 1, 2010. The company is currently expe-

riencing a shortage of funds due to a recent acquisition. Abdou Hatch, the company’s

treasurer, is considering using the funds from the bond sinking fund to cover payroll

and other bills that are coming due at the end of the month. Abdou’s brother-in-law is

a trustee in a sinking fund, who has indicated willingness to allow Abdou to use the

funds from the sinking fund to temporarily meet the company’s cash needs.

Discuss whether Abdou’s proposal is appropriate.

SA 14-2Ethics and profes-sional conduct inbusiness

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Chapter 14 Long-Term Liabilities: Bonds and Notes 655

Finn Kilgallon recently won the jackpot in the Wisconsin lottery while he was visiting

his parents. When he arrived at the lottery office to collect his winnings, he was offered

the following three payout options:

a. Receive $10,000,000 in cash today.b. Receive $2,200,000 today and $1,050,000 per year for 15 years, with the first $1,050,000

payment being received one year from today.c. Receive $1,200,000 per year for 15 years, with the first payment being received one

year from today.

Assuming that the effective rate of interest is 12%, which payout option should

Finn select? Explain your answer and provide any necessary supporting calculations.

SA 14-3Present values

Beacon Inc. has decided to expand its operations to owning and operating long-term

health care facilities. The following is an excerpt from a conversation between the chief

executive officer, Frank Forrest, and the vice president of finance, Rachel Tucker.

Frank: Rachel, have you given any thought to how we’re going to finance the acquisition of St. SeniorsHealth Care?

Rachel: Well, the two basic options, as I see it, are to issue either preferred stock or bonds. The equitymarket is a little depressed right now. The rumor is that the Federal Reserve Bank’s going to increase theinterest rates either this month or next.

Frank: Yes, I’ve heard the rumor. The problem is that we can’t wait around to see what’s going to happen.We’ll have to move on this next week if we want any chance to complete the acquisition of St. Seniors.

Rachel: Well, the bond market is strong right now. Maybe we should issue debt this time around.

Frank: That’s what I would have guessed as well. St. Seniors’s financial statements look pretty good, ex-cept for the volatility of its income and cash flows. But that’s characteristic of the industry.

Discuss the advantages and disadvantages of issuing preferred stock versus bonds.

SA 14-4Preferred stock vs.bonds

You hold a 25% common stock interest in the family-owned business, a vending ma-

chine company. Your sister, who is the manager, has proposed an expansion of plant

facilities at an expected cost of $7,500,000. Two alternative plans have been suggested

as methods of financing the expansion. Each plan is briefly described as follows:

Plan 1. Issue $7,500,000 of 10-year, 8% notes at face amount.

Plan 2. Issue an additional 100,000 shares of $10 par common stock at $40 per share,and $3,500,000 of 10-year, 8% notes at face amount.

The balance sheet as of the end of the previous fiscal year is as follows:

Thacker, Inc. Balance Sheet

December 31, 2010

AssetsCurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000,000Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000___________

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000,000______________________

Liabilities and Stockholders’ EquityLiabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000,000Common stock, $5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000Paid-in capital in excess of par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,900,000___________

Total liabilities and stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000,000______________________

Net income has remained relatively constant over the past several years. The ex-

pansion program is expected to increase yearly income before bond interest and in-

come tax from $750,000 in the previous year to $1,000,000 for this year. Your sister has

asked you, as the company treasurer, to prepare an analysis of each financing plan.

SA 14-5Financing businessexpansion

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656 Chapter 14 Long-Term Liabilities: Bonds and Notes

Moody’s Investors Service maintains a Web site at http://www.Moodys.com. One of the

services offered at this site is a listing of announcements of recent bond rating changes.

Visit this site and read over some of these announcements. Write down several of the

reasons provided for rating downgrades and upgrades. If you were a bond investor or

bond issuer, would you care if Moody’s changed the rating on your bonds? Why or

why not?

SA 14-6Bond ratings

Internet Project

The following financial data was taken from the financial statements of Williams-

Sonoma, Inc.

Fiscal Year

2007 2006 2005

Interest expense. . . . . . . . . . . . . $ 800 $ 774 $ 3,188Earnings before taxes . . . . . . . . . 36,485 20,108 13,255

1. What is the number of times interest charges are earned for Williams-Sonoma in2007, 2006, and 2005? (Round your answers to one decimal place.)

2. Evaluate this ratio for Williams-Sonoma.

SA 14-7Number of times interest charges areearned

Answers to Self-Examination Questions

1. C Earnings per share is preferred for comparingfinancing decisions because it captures the effectof alternative decisions on the earnings availableto individual shareholders (answer C). The priceof the bond issue and the discount on the bond is-sue relate to the cost of borrowing, but do not re-flect the individual shareholder impact (answersA and B). Interest expense reflects the cost of debtfinancing to the company, but does not capture theeffect on individual shareholders (answer D).

2 . B Since the contract rate on the bonds is higherthan the prevailing market rate, a rational in-vestor would be willing to pay more than theface amount, or a premium (answer B), for thebonds. If the contract rate and the market ratewere equal, the bonds could be expected to sellat their face amount (answer A). Likewise, if themarket rate is higher than the contract rate, thebonds would sell at a price below their faceamount (answer D) or at a discount (answer C).

3. A The bond carrying amount is the face amountplus unamortized premium or less unamortized

discount. For this question, the carrying amountis $900,000 less $72,000, or $828,000 (answer A).

4. B The interest portion of an installment notepayment is computed by multiplying the inter-est rate by the carrying amount of the note at thebeginning of the period. The periodic interest onbonds payable is computed by multiplying theinterest rate times the face amount of the bond(answer A). Because installment note paymentsinclude both principal and interest components,the amount of principal is reduced each periodwhich, in turn, reduces the interest portion ofeach payment (answers C and D).

5. C The balance of Discount on Bonds Payable isusually reported as a deduction from BondsPayable in the Long-Term Liabilities section (an-swer C) of the balance sheet. Likewise, a balancein a premium on bonds payable account wouldusually be reported as an addition to BondsPayable in the Long-Term Liabilities section ofthe balance sheet.

1. Prepare a table indicating the expected earnings per share on the common stock un-der each plan. Assume an income tax rate of 40%. Round to the nearest cent.

2. a. Discuss the factors that should be considered in evaluating the two plans.b. Which plan offers the greater benefit to the present stockholders? Give

reasons for your opinion.

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