At the beginning of the year, Warner Company issued $1,000,000 of 6% coupon, eff

Question

At the beginning of the year, Warner Company issued $1,000,000 of 6% coupon, effective-interest method of amortization is to be used. 10-year bonds. The a. (3points) Suppose the market rate of interest at the time of issue was 8%. P schedule for the first year and determine how much interest expense the firm shou income statement. repare an amortization YearBeginning Interest Expense Carrying Amount Interest Payment AmortizationEnding Carrying Amount (3 points) Suppose instead the market rate of interest at the time of issue was 4%. Prepare an amortization schedule for the first year. b. Amortization Ending Carrying Interest Payment YearBeginning Interest Expense Amount Carrying Amount from part (b) above, suppose after 4 years the market interest rates have risen (2 points) Following to 7%. An analyst analyzing Warner's balance sheet and only uses the carrying amount reported on the balance sheet to analyze the company's financial position would most likely: (circle one) c. i. Overestimate Warner's economic liabilities ii. Underestimate Warner's economic liabilities ii Accurately estimate Warner's economic liabilities

Explanation / Answer

The price of a bond moves inversely with interest rates.

When the market rate is less than the coupon rate the bond will have price above face value, and,

when market rate is more than the coupon rate the bond will have price below the face value.

So with 7% interest rates the bond should have a price below face value, whereas the book carrying amount would show value higher than the face value as, the bonds were issued when the interest rates were lower than the coupon.

Thus any person using the carrying value would be overestimating the economic value of the liabilities.

a) Assuming annual interest payments, the proceeds from the bond = =1000000/1.08^10+60000*(1.08^10-1)/(0.08*1.08^10) = $      865,798 Year Beginning Carrying amount Interest expense Interest payment Amortization Ending carrying amount 1 $             865,798 $         69,264 $      60,000 $             9,264 $                 875,062 b) Assuming annual interest payments, the proceeds from the bond = =1000000/1.04^10+60000*(1.04^10-1)/(0.04*1.04^10) = $   1,162,218 Year Beginning Carrying amount Interest expense Interest payment Amortization Ending carrying amount 1 $         1,162,218 $         46,489 $      60,000 $        (13,511) $             1,148,707 c) Option [i] Overestimate Warner's economic liabilities.

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