Question

Only need questions 5 & 6 answered.

Information:

• On August 1, Terry issued a $1,600,000, semi-annual, 6 year, 4.5% bond. The market rate for similar bonds on that day was 5.0%. Terry uses the effective interest method to record the amortization or premiums and discounts. Terry’s management has decided to report net bonds on the balance sheet, instead of reporting the bond and its premium or discount separately. No entries have yet been made for the bond.

Terry’s management would like to know the effect of the sale on the following ratios:

-Debt to Equity Ratio (Total Liabilities / Total Equity)

-Current Ratio

-ROA

Assignment:

Calculations

1. Calculate each of the three (3) ratios before you make any adjustments.

2. Make the appropriate journal entries, if any, to account for the new bond and any accrued interest (including any necessary changes to income tax expense).

3. Make any necessary changes to the financial statements.

4. Calculate the three (3) ratios after you make any adjustments.

Critical Thinking:

5. What do you think investors’ reaction will be to management’s decision to issue a new bond? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with the decision to issue the new debt? Why or why not?

6. Terry’s CFO has been concerned about the issuance of this bond. The company really doesn’t need the additional cash at the moment, despite some vague plans to expand in the near future. The rest of the management team, on the other hand, felt that the additional cash would allow them to repurchase shares and pay a larger dividend for the period, both of which would help to calm investors’ fears after all of the changes that needed to be made to the financial statements this period. Provide two (2) arguments that the CFO could have used to try to talk his colleagues out of issuing the bond.

Answer 1

Step 1

Question 5

Since market rate was 5%, and the offered rate of interest was only 4.5%, the investors would not be happy with the management's decision to issue new bonds by adding the interest accrued and due in new bonds, since the actual cash, which would have been received by the investors would be delayed.

Step 2

Question 6

Following arguments could have been used by CFO

1. Since market rate is 5%, deferment of payment of interest at lesser rate i.e. 4.5%, is beneficial for the Terry. Available funds would be used for various plans

   2. Payment of larger dividend would not calm the investors as repurchase of shares would not be in the interst of the Terry.