Determining Bond Prices, Interest Rates, and Financial Statement Effects Deere &
ID: 2465330 • Letter: D
Question
Determining Bond Prices, Interest Rates, and Financial Statement Effects Deere & Company's 2010 10-K reports the following footnote relating to long-term debt. Deere's borrowings include $300 million, 7.125% notes, due in 2031 (bolded below). Long-term borrowings at October 31 consisted of the following in millions of dollars:
A recent price quote (from Yahoo! Finance Bond Center) on Deere's 7.125% notes follows.
This price quote indicates that Deere's 7.125% notes have a market price of 131.84 (131.84% of face value), resulting in a yield to maturity of 4.65%.
(a) Assuming that these notes were originally issued at par value, what does the market price reveal about interest rate changes since Deere issued its notes? (Assume that Deere's credit rating has remained the same.)
Interest rates have increased.
There is not enough information.
Interest rates have remained the same.
Interest rates have declined.
(b) Does the change in interest rates since the issuance of these notes affect the amount of interest expense that Deere reports in its income statement? Explain.
Yes, the decline in interest rates results in a decline in interest expense.
Because accounting is inherently conservative, declines in interest rates are not reflected in a reduction of interest expense. However, the increase in interest expense resulting from an increase in rates is recognized.
The change in interest rates only affects the required payment on the liability and, thus, cash flow.
No, the change in interest rates since Deere issued the notes does not affect interest expense.
(c) How much cash would Deere have to pay to repurchase the 7.125% notes at the quoted market price of 131.84? (Assume no interest is owed when Deere repurchases the notes.) (Round your answer to two decimal places.)
$Answermillion
How would the repurchase affect Deere's current income?
Cash and bonds payable both decrease by the same amount. No gain or loss is recognized.
Income is not affected because the liability has been reported at fair value since inception. As a result, the repurchase price is equal to the book value and no gain or loss is recognized.
The repurchase would result in a loss on repurchase of debentures, which would lower current income.
The repurchase only affects cash flow, not income.
(d) Assuming that the notes remain outstanding until their maturity, at what market price will the notes sell on their due date in 2031?
$Answermillion
Explanation / Answer
(a)
Answer is “interest rates have declined”.
If these notes were originally issued at par, then the interest rates at the time of issue should have been equal to the stated rate of issued notes. Currently, the notes are selling at premium i.e. at a price higher than the par value. This premium states that the return provided by the notes is higher than the rate of return in the market. Hence, the interest rates have declined.
(b)
Answer is “No, the change in interest rates since Deere issued the notes does not affect interest expense.”
Once the notes have been issued at a stated interest rate, the issue shall recognize the interest expense at that rate only. The change in interest rates shall be affect the recognition of interest expense. It shall only affect the market price of the notes.
(c)
Par value of notes = $300 million
Market price = 131.84% of par value
Cash to be paid for repurchase of 7.125% notes = $300 million * 131.84% = $395.52 million
(d)
Answer is “The repurchase would result in a loss on repurchase of debentures, which would lower current income.”
The cash amount paid over and above the par value of $300 million shall be recognized as loss of repurchase of shares which shall decrease the current income.
(e)
Market price of notes = Present value of annuity of interest payments + Present value of redemption value
Annual interest payment = $300 * 7.125% = $21.375 million
Remaining interest payments till maturity (2011 to 2031) = 21
Yield to maturity = 4.650% = 0.0465
Present value of annuity = Annuity * {1 – (1+r)-n}/r
Present value of annuity of interest payments = $21.375 million * (1-1.0465-21)/0.0465 = $21.375 million * 13.2255 = $282.70 million
Present value of redemption value = $300 million / 1.046521 = $300 million / 2.5973 = $115.50 million
Market price of bonds on due date in 2031 = $282.70 million + $115.50 million = $398.20 million
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