Q21E_3 - Horngren'S Financial And Managerial Accounting

Question

Determining bond prices and interest expense

Jones Company is planning to issue $490,000 of 9%, five-year bonds payable to

borrow for a major expansion. The owner, Shane Jones, asks your advice on some

related matters.

Requirements

1. Answer the following questions:

a. At what type of bond price Jones Company will have total interest expense

equal to the cash interest payments?

b. Under which type of bond price will Jones Company’s total interest expense be

greater than the cash interest payments?

c. If the market interest rate is 12%, what type of bond price can Jones Company

expect for the bonds?

2. Compute the price of the bonds if the bonds are issued at 89.

3. How much will Jones Company pay in interest each year? How much will Jones

Company’s interest expense be for the first year?

Step-by-Step Solution

Answer

Amount of the interest paid each year is $44,100. First year interest by effective interest method is $52,332 and by straight line method is $54,880.

Step 1: Definition of the bonds issued at a discount

When the interest rate of the bonds is less than the market interest rate, this type of bond is known as bonds issued at a discount.

Step 2: Interest expense of the first year

Amount of interest paid each year:

$\begin{array}{rcl}Interest& =& Face Value\times Interest Rate\\ & =& \$490,000\times 9\%\\ & =& \$44,100\end{array}$

First-year interest expense using the effective interest method

$\begin{array}{rcl}Interest Expense& =& Carrying Amount\times Market Interest Rate\\ & =& \$436,100\times 12\%\\ & =& \$52,332\end{array}$

First-year interest expense using a straight-line method

$\begin{array}{rcl}Interest Expense& =& Interest Paid+First Year Discount Amortization\\ & =& \$44,100+\$10,780\\ & =& \$54,880\end{array}$