EI Conquistador, Inc., finances operations with both bonds and stock. Suppose EI
ID: 2490383 • Letter: E
Question
EI Conquistador, Inc., finances operations with both bonds and stock. Suppose EI Conquistador issued $500,000 of 10-year, 8% bonds payable under various market conditions. Match each market interest rate with the appropriate bond price, as follows. The three possible bond prices are $467,000; $500,000; and $536,000. EI Conquistador pays annual interest each December 31. After determining the respective bond prices, make the following journal entries for the bond discount situation (explanations are not required): How much total interest expense will EI Conquistador have during the 10-year life of these bonds?Explanation / Answer
1.
When the market interest rate is equal to the stated interest rate of bonds, then the price of bonds will be equal to its face value. When the market interest rate is lower than bond interest rate then the price of bond shall be more than the face value i.e. the bonds shall be issued at premium. This is because the return provided by the bond is more than the return provided by other similar investments available in market. Similarly, when the market interest rate is higher than bond interest rate then the price of bond shall be less than the face value i.e. the bonds shall be issued at discount.
Market Interest rate
Bond price
7%
$536,000
8%
$500,000
9%
$467,000
2.
Bond discount situation is when the market interest rate is 9%.
Price of bond = $467,000
Annual cash interest paid = $500,000 * 8% = $40,000
Discount on issue of bonds = $500,000 - $467,000 = $33,000
Life of bond = 10 year
Annual premium amortisation under straight line method = $33,000/10 = $3,300
Date
Account titles and explanation
Debit
Credit
December 31, 2006
Cash
$ 467,000
Discount on issue of bonds
$ 33,000
Bonds payable
$ 500,000
December 31, 2007
Interest expense
$ 43,300
Cash
$ 40,000
Discount on issue of bonds
$ 3,300
December 31, 2016
Interest expense
$ 43,300
Cash
$ 40,000
Discount on issue of bonds
$ 3,300
December 31, 2016
Bonds payable
$ 500,000
Cash
$ 500,000
3.
Total interest expense = $43,300 * 10 = $433,000
Market Interest rate
Bond price
7%
$536,000
8%
$500,000
9%
$467,000
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