On June 1, 2014, Mayberry Imports purchased bonds on the open market, paying $92

Question

On June 1, 2014, Mayberry Imports purchased bonds on the open market, paying $92,994. The bonds had a face value of $100,000, a stated annual interest rate of 4 percent, and a remaining time to maturity of two years. Interest was paid semiannually on November 30 and May 31, and Mayberry intended to hold the bonds until the maturity date. A. Compute the effective interest rate on the bonds. B. Record the entries made by Mayberry when it received the interest payments on November 30, 2014, and May 31, 2015. C. Compare the market value of the bond investment to its book (balance sheet) value on May 31,2015, assuming that market interest rates as of that date were 6 percent.

Explanation / Answer

Part A)

To calculate the effective rate of interest, we need to determine the nominal rate of interest. The nominal rate of interest can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Payment (Coupon Payment), PV = Present Value of Bonds (Current Selling Price) and FV = Future Value (in this case we will use Face Value of Bonds).

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Here, Nper = 2*2 = 4, PMT = 100,000*4%*1/2 = $2,000, PV = $92,994, FV = $100,000 [we use 2 since the bond is semi-annual]

Using these values in the above function/formula for Rate, we get,

Nominal Rate of Return = Rate(4,2000,-92994,100000)*2 = 7.85%

Now, we can determine the effective rate of interest with the use of following formula:

Effective Rate of Interest = (1+Nominal Rate of Interest/2)^2 - 1 = (1+7.85%/2)^2 - 1 = 8%

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Part B)

The journal entries are as follows:

Notes:

The formula for calculating interest revenue and interest receipt is given below:

1) Interest Receipt = Face Value of Bonds*Stated Rate*1/2

2) Interest Revenue = Value of Bonds at the Start of the Period*Effective Interest Rate*1/2

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Part C)

The market value of the bond as on 31st May 2015 with the market rate of interest at 6% is calculated with the use PV (Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate = Market Interest Rate, Nper = Period, PMT = Coupon Payment and FV = Future Value (Face Value of Bonds in this case).

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Here, Rate = 6%*1/2 = 3%, Nper = 1*2 = 2 (Only 1 Year 1 left to maturity), PMT = 100,000*4%*1/2 = $2,000, FV = $100,000 [we use 2 since the bond is semi-annual]

Using these values in the above function/formula for Present Value, we get,

Market Value (Present Value as on May 31, 2015) = PV(3%,2,2000,100000) = $98,086.53 or $98,087

Book Value (as on May 31, 2015 with 8% Effective Rate of Interest) = 92,994 + 1719.76 + 1,788.55 = $96,502.31

Date Account Titles Debit Credit Nov 30 2014 Cash (100,000*4%*1/2) $2,000.00 Bond Investment (3,719.76 - 2,000) $1,719.76 Interest Revenue (92,994*8%*1/2) $3,719.76 (To record interest earned on bonds as on Nov 30 and amortization of discount) May 31 2015 Cash (100,000*4%*1/2) $2,000.00 Bond Investment (3,788.55 - 2,000) $1,788.55 Interest Revenue [(92,994 + 1719.76)*8%*1/2) $3,788.55 (To record interest earned on bonds as on May 31 and amortization of discount)

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