Exercise 10-22B Effective interest amortization for a bond premium
On January 1, Year 1, Reese Incorporated issued bonds with a face value of $120,000, a stated rate of interest of 8 percent, and a five-year term to maturity. Interest is payable in cash on December 31 of each year. The effective rate of interest was 7 percent at the time the bonds were issued. The bonds sold for $124,920. Reese used the effective interest rate method to amortize the bond discount.
Required
a. Prepare an amortization table as shown next:
| Date | Cash Payment | Interest Expense | Discount Amortization | Carrying Value |
|---|---|---|---|---|
| January 1, Year 1 | 124,920 | |||
| December 31, Year 1 | 9,600 | 8,744 | 856 | 124,064 |
| December 31, Year 2 | ? | ? | ? | ? |
| December 31, Year 3 | ? | ? | ? | ? |
| December 31, Year 4 | ? | ? | ? | ? |
| December 31, Year 5 | ? | ? | ? | ? |
| Totals | 48,000 | 43,080 | 4,920 |
b. What item(s) in the table would appear on the Year 3 balance sheet?
c. What item(s) in the table would appear on the Year 3 income statement?
d. What item(s) in the table would appear on the Year 3 statement of cash flows?
Exercise 10-23B Effective interest versus straight-line amortization
On January 1, Year 1, Wright and Associates issued bonds with a face value of $800,000, a stated rate of interest of 8 percent, and a 20-year term to maturity. Interest is payable in cash on December 31 of each year. The effective rate of interest was 9 percent at the time the bonds were issued.
Required
Write a brief memo explaining whether the effective interest rate method or the straight-line method will produce the highest amount of interest expense recognized on the Year 1 income statement.
Exercise 10-24B Determining the after-tax cost of debt
The following information is available for three companies:
| Company | Bass Co. | Carp Co. | Perch Co. |
|---|---|---|---|
| Face value of bonds payable | $300,000 | $600,000 | $500,000 |
| Interest rate | 10% | 9% | 8% |
| Income tax rate | 40% | 30% | 35% |
Required
a. Determine the annual before-tax interest cost for each company in dollars.
b. Determine the annual after-tax interest cost for each company in dollars.
c. Determine the annual after-tax interest cost for each company as a percentage of the face value of the bonds.
Exercise 10-25B Determining the effects of financing alternatives on ratios
Cascade Industries has the following account balances:
| Account | Amount |
|---|---|
| Current assets | $30,000 |
| Noncurrent assets | $120,000 |
| Current liabilities | $15,000 |
| Noncurrent liabilities | $75,000 |
| Stockholders’ equity | $60,000 |
The company wishes to raise $50,000 in cash and is considering two financing options: Cascade can sell $50,000 of bonds payable, or it can issue additional common stock for $50,000. To help in the decision process, Cascade’s management wants to determine the effects of each alternative on its current ratio and debt-to-assets ratio.
Required
a. Help Cascade’s management by completing the following chart:
| Ratio | Currently | If Bonds Are Issued | If Stock Is Issued |
|---|---|---|---|
| Current ratio | |||
| Debt-to-assets ratio |
b. Assume that after the funds are invested, EBIT amounts to $18,000. Also assume the company pays $5,000 in dividends or $5,000 in interest, depending on which source of financing is used. Based on a 30 percent tax rate, determine the amount of the increase in retained earnings that would result under each financing option.
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