In order to fund its rapid business expansion, on January 1, Year 1, the Koala C

Question

In order to fund its rapid business expansion, on January 1, Year 1, the Koala Company issued a two year 10% coupon bond. The face value is $100,000. Interest is payable annually on December 31 of each year. The implied effective (market) interest rate was 12%.

There was a huge increase in the market effective interest rate at the end of Year 1. On January 1 of Year 2, Koala’s bonds were traded at $88,000. The company took the opportunity to retire its existing bonds by issuing new bonds with one year maturity on January 1 of Year 2 with a coupon rate being the effective market rate on that day. The new bonds were issued at par and raised $88,000. All the proceeds from the new bond issuance were used to retire the bonds issued in Year 1.

Answer the following:

a) What's the price of the bond?

b) What are the journal entries for interest expenses at the end of year 1

c) Balance of bond account at the end of year 1

d) Show the journal entries for the new bond issued at par on Jan 1, year 2

e) What's the impact on net income when the first bond is retired? (hint: is there a gain/loss?)

f) Show the journal entries on Dec 31, Year 2

Explanation / Answer

a)The price of the bond is the present value of cash flows

b)

Workings

c) Bond Balance at the end of the year = 98406

d)

e) he first bond had an unamortised discount of 1786. So the value of the bond was 98214. The bonds were able to be retired for 88000. There is a gain of 10214.

f)The value of bond at the end of 1 year is 88000. The value factor = 110000/88000 = 1.25. Hence, the market rate is 25%.

Journal entries for new bonds will be

Cash Flow PV at 12% PV of cash flows Year 1 interest 10000 0.892857 8928.571429 Year 2 interest 10000 0.797194 7971.938776 Redemption 100000 0.797194 79719.38776 Proce of the bond 96620

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