Question

On August 31, 2015, Chickasaw Industries issued $25 million of its 30-year, 6% convertible bonds dated August 31, priced to yield 5%. The bonds are convertible at the option of the investors into 1,500,000 shares of Chickasaw's common stock. Chickasaw records interest expense at the effective rate. On August 31,2018, investors in Chickasaw's convertible binds tendered 20% of the bonds for conversion into common stock that had a market value of $20 per share on the date of the conversion. On January 1, 2017, Chickasaw Industries issued $40 million of its 20-year, 7% bonds dated January 1 at a price yield 8%. On December 31, 2018, the bonds were extinguished early through acquisition in the open market by Chickasaw for $40.5 million.

Required:

1. Using the book value method, would recording the conversion of the 6% convertible bonds into common stock affect earnings? If so, by how much? Would earnings be affected if the market value method is used? If so, by how much?

2. Were the 7% bonds issued at face value, at a discount or at a premium? Explain.

3. Would the amount of interest expense for the 7% bonds be higher in the first year or second year of the term to maturity? Explain.

4. How should gain or loss on early extinguishment of debt be determined? Does the early extinguishment of the 7% bonds result in a gain or loss? Explain.

Answer 1

1

Book value of the bonds = $25 million

Extinguished price = $20 * 1.5 million = $30 million

Hence there is a loss for the company.

Loss on books = $5 million

Market value approach: The market price would be significantly different from the book value since the yield and the coupon rate are different. Hence market value would be different from the book value and hence the final profit/loss would be changed.

Market value of bonds = 28.84 million (Using the yield and the coupon rate)

Hence the loss is less in this case.

2

Yield is higher than coupon rate. Hence the bonds were issued at a discount.

3

Interest expense would remain same and equal to the coupon payment. Interest is fixed and hence it will not change.

4

Book value of the bonds = $40 million (On Jan 1, 2017)

Extinguished price = $40.5 million

Hence there is a loss for the company.

Loss on books = $0.5 million

Market value approach: The market price would be significantly different from the book value since the yield and the coupon rate are different. Hence market value would be different from the book value and hence the final profit/loss would be changed.

Market value of bonds on 31 Dec 2018 = $36.25 million (Using the yield and the coupon rate)

Hence there is a bigger loss for the company.