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On January 1, Year 1, the Christie Companies issued bonds with a face value of $500,000, a stated rate of interest of 10 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 8 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.
The following information is available for three companies:
| Rope Co. | Chain Co. | Line Co. | |
|---|---|---|---|
| Face value of bonds payable | $400,000 | $700,000 | $600,000 |
| Interest rate | 8% | 7% | 6% |
| Income tax rate | 35% | 20% | 25% |
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.
Clayton Industries has the following account balances:
Current assets $20,000
Noncurrent assets $80,000
Current liabilities $10,000
Noncurrent liabilities $50,000
Stockholders’ equity $40,000
The company wishes to raise $40,000 in cash and is considering two financing options: Clayton can sell $40,000 of bonds payable, or it can issue additional common stock for $40,000. To help in the decision process, Clayton’s management wants to determine the effects of each alternative on its current ratio and debt-to-assets ratio.
Required
a. Help Clayton’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 $12,000. Also assume the company pays $4,000 in dividends or $4,000 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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