I need help with Requirments 5, That\'s the one that\'s giving me a hard time fo

Question

I need help with Requirments 5, That's the one that's giving me a hard time for the most part.

Legacy issues $325,000 of 5%, four-year bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31, They are issued at S292, 181 and their market rate is 8% at the issue date. Problem 14-6A Straight-Line: Amortization of bond Required 1. Prepare the January 1, 2013, journal entry to record the bonds' issuance 2. Determine the total bond interest expense to be recognized over the bonds' life. 3. Prepare a straight-line amortization table like the one in Exhibit 14.7 for the bonds' first two years 4. Prepare the journal entries to record the first two interest payments. P1 P2 P3 Check 12) 397819 13) 12/31/2014 carrying value, $308,589 Analysls Component 5. Assume the market rate on January 1, 2013, is 4% instead of 8% without providing numbers, describe how this change affects the amounts reported on Legacy's financial statements.

Explanation / Answer

There is inverse relationship between interest rates and bond prices. An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity.

For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%).

For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).

Now that we have an idea of how a bond's price moves in relation to interest-rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.

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