A company issued 10%, 10-year, $10,000,000 par value bonds that pay interest semiannually on April 1 and October 1. The bonds are dated April 1, 2004 and are issued on that date. The market rate of interest for such bonds on April 1, 2004 is 8%. The company uses the effective interest rate method of amortization.
1. Prepare a bond amortization schedule.
2. Prepare all journal entries made for the issuance of the bonds, and the October 1, 2006 and April 1, 2008 interest payments.
3. Prepare the adjusting entry on December 31, 2012.
4. Assume that 50% of the bonds are called on October 2, 2012 at 98. Make the necessary journal entries. (Do not accrue interest for one day).
5. Assume that the market rate was 12% when the bonds were issued. Make the necessary journal entry to record the issuance of the bonds.
The key to working a problem like this is in a) determining the price of the bonds at issue date and b) preparing the bond amortization schedule. IF you get the amortization schedule correct, then all you have to do is fill in the blanks on the journal entries.
a) price of the bonds: If the market rate of interest is 8% but these bonds are yielding 10%, will these bonds sell at face value, premium or at a discount? People will pay more for these bonds, so they will sell at a premium. To calculate the amount that the company will charge, you add
1) the present value of the face amount due in 10 years (20 payments, since the bonds pay interest semiannually) or $10,000,000 x pv of $1 for 20 periods at 4%, and 2) the present value of the 20 annual interest payments (payments are based on the stated interest of 5% times the face amount of the bonds, or $500,000 x pv of an annuity of for 20 periods at 4%.
IN OTHER WORDS, buyers are paying you an amount that will, in fact, yield them 8% ...
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